Beijing has taken steps to enhance its onshore cross-currency swap (CCS) market as it continues to reform its capital markets.
The State Administration of Foreign Exchange (Safe), China’s foreign exchange regulator, issued a notice last week allowing banks that trade in the interbank market to start trading CCS on June 11 without exchanging principals on the value and maturity dates.
A CCS is an agreement between two parties to exchange interest payments denominated in two different currencies for a specified term. One interest payment is typically calculated using a floating rate index such as US dollar Libor. The other interest payment is based upon a fixed rate or another floating rate index denominated in a different currency.
While this usually involves the exchange of principal and interest in one currency for the same in another currency, this can involve the non-delivery of the principal. Such swaps usually have maturities of one to five years as they are designed to hedge against interest-rate risks in foreign currency-denominated bonds, loans and other types of debt.
While this is viewed as a positive development for the Chinese derivatives market, analysts believe that the changes will have a limited impact and that the CCS market will take time to take-off given the fact that liquidity is tight.
“The CCS market is very illiquid and I think the development will be very slow,” said Frances Cheung, senior strategist at Crédit Agricole to Asiamoney PLUS in a telephone interview on June 11.
Another rates analyst at a British bank highlighted: “We rarely talk about it over here. Even while [the non-principal CCS] is new, there isn’t much volume that we are talking about.”
Because of this, China’s CCS market has not been on the radar of many analysts. For those who are following the market closely, their main concern is the liquidity in longer maturities.
HSBC was one of the first that were able to start trading the derivative on the day of launch. The USD/CNY swap has a notional amount of US$10 million traded with its counterparty Industrial Bank.
While the bank declined to comment on the tenor of the deal, market participants believe it is six months.
While some market experts believe that there is liquidity for shorter tenors of less than a year, a CCS should be used for longer durations instead, especially for Chinese financial institutions with substantial foreign exchange (FX) exposures.
“The very short dated tenor of this [HSBC] transaction doesn’t really show the fundamental value of the CCS exchange,” said Linan Liu, China rates strategist at Deustche Bank to Asiamoney PLUS in a telephone interview on June 11.
“I don’t think there will be a lot of interest in CCS in this format going forward,” she added. “The whole point of doing a CCS is really to be able to do it on a slightly long-dated tenor – one year or longer – because if you have a very large exposure on the FX, it’s a funded position.”
As a result, the Chinese regulators need to do more to bolster the onshore CCS market, whether the principal is exchanged at the start or end of the transaction. Moreover, the non-principal exchange currency swap is restricted to banks only.
“The government should allow corporates and investors to access non-deliverable CCS markets in order to improve liquidity because we need more clients, not only within the interbank market,” said a China-based rates strategist to Asiamoney PLUS in a telephone interview.
“I think it would be important to have one leg of the principal exchange. Without the principal exchanged this essentially becomes an interest rate hedge,” added Liu. “It makes sense to first relax or remove the net open positions (NOP) limit and have revise of the existing rule to allow principal exchange one leg of the transaction.”
On April 16, Safe announced changes to the China’s NOP. The lower limit on foreign currency NOP was further lowered from zero to a negative level, allowing banks to maintain net short FX positions against the renminbi.
An NOP is the difference between a total open long (receivable) and an open short (payable) positions in any given assets, be it a securities, foreign exchange, or commodities.
Another banking expert added: “I think if they were to give more guidelines on what it is allowed or not allowed to do, that would definitely lead to more product innovation and liquidity.”