China’s repo market: a guide to the present, an eye on the future
22 November 2022
Richard Comotto, senior consultant to the International Capital Market Association, speaks to Bob Currie about the release of the China chapter of ICMA’s guide to Asian repo markets and his thoughts on how this financing marketplace might develop
Image: stock.adobe.com/zhu difeng
The International Capital Market Association (ICMA) has released a guide to China’s repo market, representing the fifth chapter in its domestic repo markets in Asia.
This latest chapter provides a detailed introduction to repo market activities on the Chinese mainland, including analysis of the evolution of the market, both its interbank and exchange-traded markets, products and trading activities and market infrastructure, along with a review of the regulatory and legal framework and its ongoing development.
Authored by Richard Comotto, senior consultant to the ICMA’s European Repo and Collateral Council and longstanding repo market expert, this contribution follows on the back of domestic repo market guides for Japan, Indonesia, Vietnam and the Philippines which have been released in stages earlier this year.
The latest chapter notes that China has a 30-year history of repo trading, with activity building from informal transactions conducted on local exchanges in the early 1990s to a market today that generates almost US$220 trillion annually in turnover, equivalent to an average daily turnover of US$850 billion or CNY 5.6 trillion.
Given the scale of the repo market in China, Comotto advises that it should be compared with other large repo markets globally, rather than its smaller Asian regional counterparts. The repo market is now the largest fixed income and money market in China, with repo turnover during 2021 of CNY 1,395.4 trillion compared to CNY 214.5 trillion cash trading in bonds and CNY 118.8 trillion in unsecured interbank lending.
While China’s domestic repo market has grown substantially from where it was 30 years ago, he suggests that the market may now have entered something of a cul-de-sac in terms of the opportunities it offers for further development. It is not a conventional repo market, he notes, insofar as some of the functions it fulfils would typically be performed through other instruments or trading mechanisms in other jurisdictions. In its current form, it has potential to grow further as a domestic market, but it offers only limited possibilities for integration with the international financial markets and to evolve as a funding channel that is attractive to international participants.
Collateral illiquidity
The guide concludes that, although the repo market is the most efficient and liquid financial market in China, the underlying cash market for securities deployed as collateral is relatively illiquid, with very low turnover, and collateral illiquidity is a systemic risk in this market.
The consequence, says Comotto, is that liquidity-providers (ie collateral takers) will typically avoid term business and limit their financing trades to overnight, in the hope that they will exit the transaction before anything goes wrong.
More specifically, given the lack of liquidity in the underlying cash securities markets, it is difficult to accurately value collateral. Collateral-takers may have broad confidence in the default characteristics of government bonds, municipal bonds and policy bank bonds delivered as collateral in repo transactions — believing that the Chinese government is likely to back its government debt, along with debt issued by government agencies and state-owned enterprises.
However, given the illiquidity of underlying securities markets, it is challenging to manage the mark-to-market and to track the movement in collateral valuation over time. These factors, collectively, represent a significant constraint on the future development of the market.
Although the one-day duration of most repo transactions does mitigate this liquidity risk to investors, it does present a significant funding risk for borrowers. Comotto notes that extensive use of short-term wholesale funding to generate leverage and to manage maturity transformation exposes the repo market to risk of sudden deleveraging.
A further source of systemic risk arises because almost all repo trades are pledged transactions, which are effectively secured loans rather than true repo. In the event of a counterparty default, Comotto notes that such repos would fall within the scope of the statutory insolvency regime and Chinese bankruptcy law, which is little tested and may delay or block access to collateral.
A new Futures and Derivatives Law (FDL) came into effect in China on 1 August 2022 which recognises the enforceability of close-out netting, but only for futures. ISDA has also published a netting opinion for the derivatives market in China that aligned with the enactment of this FDL legislation.
These developments notwithstanding, Comotto remains cautious about how far the market has advanced in terms of the surety available to repo market participants.
“This does not currently offer market participants the assurances that they require from a mature financing market,” says Comotto. “This demands that their rights to the collateral are clearly protected, typically through transfer of title, and that is not currently the case in China. Further, in case of counterparty default, it is unclear whether close-out netting could be assured for mutual positions under China’s existing insolvency law, notwithstanding progress with derivatives. The regulatory authorities have issued statements indicating that the rights of collateral takers will be protected in case of a counterparty default, but that assurance is untested in practice.”
More broadly, pledged repo does little to encourage liquidity in the underlying securities market because cash lenders are not able to re-use pledged collateral, for example to cover short positions.
Trading and post-trade infrastructure
The repo market in China is divided across the Interbank Market and two stock exchanges, the Shanghai Stock Exchange and Shenzhen Stock Exchange. The Interbank Market is a largely wholesale and quasi-OTC market. The exchanges are centralised markets and primarily support retail activity.
SFT asked Richard Comotto how he expects the relative market share of the Interbank Market and stock exchanges to evolve for repo trading in times ahead. The exchanges raised their share of trading turnover to 35 per cent in 2017, before falling back in the face of tighter monetary policy and regulation to just over 20 per cent at the end of 2021 (p 5).
“Looking back five years or so, it seemed likely that the stock exchanges would strengthen their market share of the Chinese repo market on the back of greater interest in credit collateral,” explains Comotto. “However, in practice, that trend was not maintained. Shocks to the market, including the challenges presented by the Covid-19 pandemic, have focused repo trade through the longer established and more liquid Interbank Market, which has also been encouraged by central bank participation through this channel.”
With the move to “risk off” that has accompanied these shocks, this has slowed growth of repo trading through the stock exchanges. If risk appetite returns, Comotto predicts that the exchanges may again start to encroach on the market share of the Interbank Market. On the other hand, if the Chinese government increases its issuance of government bonds, this is likely to provide additional stimulus to repo trades against government debt collateral through the Interbank Market.
In theory, Comotto notes, the Interbank Market trades on the China Foreign Exchange Trading System (CFETS), which supports trading and data services for repo, cash bonds, foreign exchange and OTC derivatives. In reality, repo market participants commonly trade bilaterally off CFETS, using voice or chat, with CFETS used to report the transaction in keeping with the regulatory obligation in the Chinese market for OTC transactions.
Comotto believes there is small probability that repo trading activity will move substantially from voice to electronic trading on CFETS in the immediate future. To support electronic trading, it is necessary to offer strong liquidity in standardised trading instruments and contracts — and this is currently not available in China’s domestic repo market. Credit availability is also a constraint, particularly in the Interbank market.
The financial authorities in many emerging capital markets are keen to demonstrate that they are building an international-standard trading and post-trade infrastructure. However, automatic trading systems operating via a central limit order book cannot operate efficiently without strong trade flow. Comotto notes that in the US and Europe, this has been driven particularly by a large and vibrant repo market supporting short-term financing of government bonds. However, China’s domestic market cannot currently deliver this level of repo market liquidity.
At clearing level, two CSDs are currently providing clearing and settlement services for the Interbank Market. China Central Depository and Clearing Corporation (CCDC, or Chinabond) is the designated CSD for government bonds and enterprise bonds and settles approximately 80 per cent of the Interbank Market. The Shanghai Clearing House (SHCH) settles repo against other collateral, typically commercial paper and medium-term notes. Both CSDs offer DvP central bank money settlement, with CeBM payments supported by the PBOC’s China National Advanced Payments System. Settlement is typically T+0, although next-day settlement is permitted.
In October 2018, the central bank granted permission for the CDCC and SHCH to offer triparty collateral management services — which went live at SHCH in October 2018 and at CDCC in April 2019 — with potential for custodian banks to offer triparty collateral management services at a later time. However, triparty volumes are currently reported to be “insignificant” since the launch of these services (p 7).
SHCH has also proposed a GC financing facility involving its CCP and its triparty collateral management service (similar to the GCF service in the US, €GCPlus and GC Pooling in the EU and £GC in the UK). However, again, there has been little significant financing activity against GC baskets through this channel.
For repos traded on the exchanges, clearing and settlement takes place on the China Securities Depository and Clearing Corporation (CSDC, or Chinaclear), which supports T+1 settlement against commercial bank money payment. For repo trades executed on the stock exchanges (but not for OTC repos reported after execution to the exchanges), CSDC offers a CCP service to counterparties trading standardised repo against AAA-rated bonds.
This provides guaranteed settlement and anonymity to the counterparties, Comotto notes, but does not align with the CPMI/IOSCO’s Principles for Financial Market Infrastructures. CSDC also provides triparty collateral management services to both exchanges, including automatic collateral allocation.
“This again shows evidence that China’s financial authorities are committed to developing a post-trade infrastructure, including clearing services, that mirror the architecture employed in international capital markets,” says Comotto. “However, I do not anticipate significant take-up of these central clearing services for repo market trades in the near term. Fundamentally, CCPs require volume in standard easily-nettable products. Whereas the US and European markets have electronic platforms supporting high trading volumes in short-term government bond repo, this trade flow does not currently exist in China’s domestic repo marketplace. In the Interbank market, a major share of business is bank-to-customer and therefore unlikely to drive significant volume through the central clearing solution established by SCHC.”
Concluding thoughts
In concluding, Richard Comotto highlights the important role that the Interbank Market has played since its inception in 1997 in supporting the central bank’s move towards an interest rate-based monetary policy framework. This has facilitated the People’s Bank of China’s move from quantitative credit targets and direct interest rate guidance towards a monetary framework guided by daily open market intervention, reserve averaging, standing facilities and strategic policy signals.
Comotto notes that an efficient repo market provides a secure medium for open market operations, while repo rates provide an accurate indicator of the cost of wholesale funding, providing an effective benchmark for pricing risk and short-term financial assets.
China’s desire to be integrated more fully into the international financial system, and to play a more prominent role in this system, is likely to prompt reforms to address some of the obstacles to development identified in this article. “Reforms to China’s bankruptcy law will be an important starting point,” notes Comotto. “If the financial authorities can encourage the development of a title transfer repo, supported by a robust bankruptcy law that protects collateral rights and netting against the insolvency regime, this would be a major step forward.”
From a market structure perspective, he notes that China would benefit from promoting the development of a true dealer-to-dealer market, rather than the predominantly bank-to-customer arrangements that dominate the Interbank Market currently, where a wide range of trading entities are invited to participate.
These will be the key steps in developing a repo market that supports the wider development of China’s financial markets and economy. “The People’s Bank of China is fully aware of the importance of these reforms and progress will be dependent on whether political decision-makers will be willing to follow through with these changes, preparing the foundation for the next phase of China’s repo market development,” concludes Comotto
This latest chapter provides a detailed introduction to repo market activities on the Chinese mainland, including analysis of the evolution of the market, both its interbank and exchange-traded markets, products and trading activities and market infrastructure, along with a review of the regulatory and legal framework and its ongoing development.
Authored by Richard Comotto, senior consultant to the ICMA’s European Repo and Collateral Council and longstanding repo market expert, this contribution follows on the back of domestic repo market guides for Japan, Indonesia, Vietnam and the Philippines which have been released in stages earlier this year.
The latest chapter notes that China has a 30-year history of repo trading, with activity building from informal transactions conducted on local exchanges in the early 1990s to a market today that generates almost US$220 trillion annually in turnover, equivalent to an average daily turnover of US$850 billion or CNY 5.6 trillion.
Given the scale of the repo market in China, Comotto advises that it should be compared with other large repo markets globally, rather than its smaller Asian regional counterparts. The repo market is now the largest fixed income and money market in China, with repo turnover during 2021 of CNY 1,395.4 trillion compared to CNY 214.5 trillion cash trading in bonds and CNY 118.8 trillion in unsecured interbank lending.
While China’s domestic repo market has grown substantially from where it was 30 years ago, he suggests that the market may now have entered something of a cul-de-sac in terms of the opportunities it offers for further development. It is not a conventional repo market, he notes, insofar as some of the functions it fulfils would typically be performed through other instruments or trading mechanisms in other jurisdictions. In its current form, it has potential to grow further as a domestic market, but it offers only limited possibilities for integration with the international financial markets and to evolve as a funding channel that is attractive to international participants.
Collateral illiquidity
The guide concludes that, although the repo market is the most efficient and liquid financial market in China, the underlying cash market for securities deployed as collateral is relatively illiquid, with very low turnover, and collateral illiquidity is a systemic risk in this market.
The consequence, says Comotto, is that liquidity-providers (ie collateral takers) will typically avoid term business and limit their financing trades to overnight, in the hope that they will exit the transaction before anything goes wrong.
More specifically, given the lack of liquidity in the underlying cash securities markets, it is difficult to accurately value collateral. Collateral-takers may have broad confidence in the default characteristics of government bonds, municipal bonds and policy bank bonds delivered as collateral in repo transactions — believing that the Chinese government is likely to back its government debt, along with debt issued by government agencies and state-owned enterprises.
However, given the illiquidity of underlying securities markets, it is challenging to manage the mark-to-market and to track the movement in collateral valuation over time. These factors, collectively, represent a significant constraint on the future development of the market.
Although the one-day duration of most repo transactions does mitigate this liquidity risk to investors, it does present a significant funding risk for borrowers. Comotto notes that extensive use of short-term wholesale funding to generate leverage and to manage maturity transformation exposes the repo market to risk of sudden deleveraging.
A further source of systemic risk arises because almost all repo trades are pledged transactions, which are effectively secured loans rather than true repo. In the event of a counterparty default, Comotto notes that such repos would fall within the scope of the statutory insolvency regime and Chinese bankruptcy law, which is little tested and may delay or block access to collateral.
A new Futures and Derivatives Law (FDL) came into effect in China on 1 August 2022 which recognises the enforceability of close-out netting, but only for futures. ISDA has also published a netting opinion for the derivatives market in China that aligned with the enactment of this FDL legislation.
These developments notwithstanding, Comotto remains cautious about how far the market has advanced in terms of the surety available to repo market participants.
“This does not currently offer market participants the assurances that they require from a mature financing market,” says Comotto. “This demands that their rights to the collateral are clearly protected, typically through transfer of title, and that is not currently the case in China. Further, in case of counterparty default, it is unclear whether close-out netting could be assured for mutual positions under China’s existing insolvency law, notwithstanding progress with derivatives. The regulatory authorities have issued statements indicating that the rights of collateral takers will be protected in case of a counterparty default, but that assurance is untested in practice.”
More broadly, pledged repo does little to encourage liquidity in the underlying securities market because cash lenders are not able to re-use pledged collateral, for example to cover short positions.
Trading and post-trade infrastructure
The repo market in China is divided across the Interbank Market and two stock exchanges, the Shanghai Stock Exchange and Shenzhen Stock Exchange. The Interbank Market is a largely wholesale and quasi-OTC market. The exchanges are centralised markets and primarily support retail activity.
SFT asked Richard Comotto how he expects the relative market share of the Interbank Market and stock exchanges to evolve for repo trading in times ahead. The exchanges raised their share of trading turnover to 35 per cent in 2017, before falling back in the face of tighter monetary policy and regulation to just over 20 per cent at the end of 2021 (p 5).
“Looking back five years or so, it seemed likely that the stock exchanges would strengthen their market share of the Chinese repo market on the back of greater interest in credit collateral,” explains Comotto. “However, in practice, that trend was not maintained. Shocks to the market, including the challenges presented by the Covid-19 pandemic, have focused repo trade through the longer established and more liquid Interbank Market, which has also been encouraged by central bank participation through this channel.”
With the move to “risk off” that has accompanied these shocks, this has slowed growth of repo trading through the stock exchanges. If risk appetite returns, Comotto predicts that the exchanges may again start to encroach on the market share of the Interbank Market. On the other hand, if the Chinese government increases its issuance of government bonds, this is likely to provide additional stimulus to repo trades against government debt collateral through the Interbank Market.
In theory, Comotto notes, the Interbank Market trades on the China Foreign Exchange Trading System (CFETS), which supports trading and data services for repo, cash bonds, foreign exchange and OTC derivatives. In reality, repo market participants commonly trade bilaterally off CFETS, using voice or chat, with CFETS used to report the transaction in keeping with the regulatory obligation in the Chinese market for OTC transactions.
Comotto believes there is small probability that repo trading activity will move substantially from voice to electronic trading on CFETS in the immediate future. To support electronic trading, it is necessary to offer strong liquidity in standardised trading instruments and contracts — and this is currently not available in China’s domestic repo market. Credit availability is also a constraint, particularly in the Interbank market.
The financial authorities in many emerging capital markets are keen to demonstrate that they are building an international-standard trading and post-trade infrastructure. However, automatic trading systems operating via a central limit order book cannot operate efficiently without strong trade flow. Comotto notes that in the US and Europe, this has been driven particularly by a large and vibrant repo market supporting short-term financing of government bonds. However, China’s domestic market cannot currently deliver this level of repo market liquidity.
At clearing level, two CSDs are currently providing clearing and settlement services for the Interbank Market. China Central Depository and Clearing Corporation (CCDC, or Chinabond) is the designated CSD for government bonds and enterprise bonds and settles approximately 80 per cent of the Interbank Market. The Shanghai Clearing House (SHCH) settles repo against other collateral, typically commercial paper and medium-term notes. Both CSDs offer DvP central bank money settlement, with CeBM payments supported by the PBOC’s China National Advanced Payments System. Settlement is typically T+0, although next-day settlement is permitted.
In October 2018, the central bank granted permission for the CDCC and SHCH to offer triparty collateral management services — which went live at SHCH in October 2018 and at CDCC in April 2019 — with potential for custodian banks to offer triparty collateral management services at a later time. However, triparty volumes are currently reported to be “insignificant” since the launch of these services (p 7).
SHCH has also proposed a GC financing facility involving its CCP and its triparty collateral management service (similar to the GCF service in the US, €GCPlus and GC Pooling in the EU and £GC in the UK). However, again, there has been little significant financing activity against GC baskets through this channel.
For repos traded on the exchanges, clearing and settlement takes place on the China Securities Depository and Clearing Corporation (CSDC, or Chinaclear), which supports T+1 settlement against commercial bank money payment. For repo trades executed on the stock exchanges (but not for OTC repos reported after execution to the exchanges), CSDC offers a CCP service to counterparties trading standardised repo against AAA-rated bonds.
This provides guaranteed settlement and anonymity to the counterparties, Comotto notes, but does not align with the CPMI/IOSCO’s Principles for Financial Market Infrastructures. CSDC also provides triparty collateral management services to both exchanges, including automatic collateral allocation.
“This again shows evidence that China’s financial authorities are committed to developing a post-trade infrastructure, including clearing services, that mirror the architecture employed in international capital markets,” says Comotto. “However, I do not anticipate significant take-up of these central clearing services for repo market trades in the near term. Fundamentally, CCPs require volume in standard easily-nettable products. Whereas the US and European markets have electronic platforms supporting high trading volumes in short-term government bond repo, this trade flow does not currently exist in China’s domestic repo marketplace. In the Interbank market, a major share of business is bank-to-customer and therefore unlikely to drive significant volume through the central clearing solution established by SCHC.”
Concluding thoughts
In concluding, Richard Comotto highlights the important role that the Interbank Market has played since its inception in 1997 in supporting the central bank’s move towards an interest rate-based monetary policy framework. This has facilitated the People’s Bank of China’s move from quantitative credit targets and direct interest rate guidance towards a monetary framework guided by daily open market intervention, reserve averaging, standing facilities and strategic policy signals.
Comotto notes that an efficient repo market provides a secure medium for open market operations, while repo rates provide an accurate indicator of the cost of wholesale funding, providing an effective benchmark for pricing risk and short-term financial assets.
China’s desire to be integrated more fully into the international financial system, and to play a more prominent role in this system, is likely to prompt reforms to address some of the obstacles to development identified in this article. “Reforms to China’s bankruptcy law will be an important starting point,” notes Comotto. “If the financial authorities can encourage the development of a title transfer repo, supported by a robust bankruptcy law that protects collateral rights and netting against the insolvency regime, this would be a major step forward.”
From a market structure perspective, he notes that China would benefit from promoting the development of a true dealer-to-dealer market, rather than the predominantly bank-to-customer arrangements that dominate the Interbank Market currently, where a wide range of trading entities are invited to participate.
These will be the key steps in developing a repo market that supports the wider development of China’s financial markets and economy. “The People’s Bank of China is fully aware of the importance of these reforms and progress will be dependent on whether political decision-makers will be willing to follow through with these changes, preparing the foundation for the next phase of China’s repo market development,” concludes Comotto
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