In a sign that the credit derivatives market in Asia is further hotting up, Barclays Capital has announced the launch of the iTraxx Asia ex-Japan CDS (Credit Default Swap) indices. Barclays did not design the index, but will act as market maker.
The index will be administered by the International Index Company. In Asia, the iTraxx will replace the previous Trac-X Asia and provide thee additional sub-indices for Korea, Great China and other Asia Credit Derivative Swaps (CDS) contracts.
The index is composed of bonds from across the region ex-Japan, with index buyers gaining exposure to primarily investment grade bonds. If investors, including banks, hedge funds and corporate treasuries, want a more narrow exposure they can choose the sub indices.
Credit derivatives, mainly Credit Derivatives Swaps (CDS), are increasingly popular in Asia, although bankers say it is difficult to estimate volume and turnover as they are over-the-counter instruments.
Selling protection, or investing in one of these products, entails an investor taking exposure to a basket of credits, for which the protection seller receives a fee. The commitment to pay the fee can also be traded.
Banks that buy protection can lighten their capital adequacy ratio by moving exposure off balance sheet. This is because it is the seller of protection, which gets hit if the underlying credit defaults.
Practitioners say that while volume cannot be measured, it has grown rapidly, with Chinese investors especially eager to get into the market. Indeed, according to mainland-based investment bankers, Chinese banks are increasingly big sellers of protection in this relatively recent market.
The popularity of the instruments among Chinese investors is attributed to their search for yield. This stems from the fact that China's stock market is largely dysfunctional, corporate bond issuance is tiny and fee income from consumer lending.
Chinese banks are big buyers of foreign corporate and government investment grade bonds because they are keen on the yield. They are also keen sellers of protection against similar pools of credits says HSBC's chief of treasury Terrance Hui.
By pledging to cover the defaults of the debtors in return for a fee, the Chinese banks do not have to put down the full value of the bond. This increases the banks' ability to leverage capital, although the exact extent depends on how the derivatives are treated on the balance sheet.
Things get slightly murky here, especially for the big four mainland state banks, which are not listed, and whose financial reports go into scant detail about their derivatives transactions, according to Ryan Tsang, a mainland banking expert at Standards and Poor's. Of the 11 shareholding banks, including the likes of Bank of Communications and Minsheng Bank, only five are listed and need to comply with international accounting standards.
One of the aims of the Basel II accord was to force banks to be more transparent about their treatment of derivatives. Chinese banks are not signatories, although similar domestic legislation has been enacted.
Another advantage of using derivatives is that they are some times more liquid than the bonds they derive their value from. One measure of liquidity is the size of the bid-offer spread, and according to Pieter van der Schaft, an analyst at Barclays Capital, that has frequently narrowed to one basis points.
Credit derivatives are natural hedging instruments, since bond holders can hedge by buying protection in the market. Until recently, hedging was the only function Chinese banks were able to explore. However, with the passing of regulatory control from the State Administration of Foreign Exchange (SAFE) to the securities and banking regulators, banks have been allowed to apply for licenses which will permit them to trade CDs to make a profit, rather than hedging.
Specialists say it is clear Chinese banks are moving up the learning curve. But as hapless US treasurers have found, merely investing in a fancy instrument at the behest of investment bankers is no guarantee of profit. Investment bankers are keen sellers of this instrument since they take out a cut by way of the bid-offer price.
One observer concludes that the key indicator to watch is if Chinese banks moved down the credit curve from investment to non-investment grade credits. If that happens, despite the tempting fees, some believe Chinese banks could be storing up a lot of trouble for themselves.
