New rules for trading in China’s derivatives market have provided a major attraction for foreign banks, which are preparing for the country to open up fully in 2007. Natasha de Teran reports.

As China prepares to open up its banking sector by 2007 in accordance with its World Trade Organisation accession terms, the country is increasingly becoming a major focus for banks, exchanges and others in the derivatives industry. Although the date is still far off, and while there is a good degree of scepticism about the extent to which the country is committed to the programme, the sheer potential of the market has meant that banks are already gearing up for the occasion.

In February this year, the derivatives industry became the focus of attention, when the China Banking Regulatory Commission (CBRC) introduced the first set of rules governing banks’ and other financial institutions’ derivatives activities. The new rules purported to clear up previous ambiguities and give regulatory certainty for those wishing to conduct derivatives business in the country.

Bob Pickel, chief executive of the International Swaps and Derivatives Association, which worked together with the CBRC on developing the rules, says: “This was a key development, widely welcomed by financial institutions, which will provide a major boost to the development of the over-the-counter (OTC) derivatives markets in China. The scope of the market in China and potential opportunities for investment banks in the region is hard to estimate with any accuracy, but in general terms, it is evident that the move represents the awakening of a potentially very vibrant market.”

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Bob Pickel: new rules will awaken the market

One of the most significant changes in the new rules is that they now very clearly sanction OTC derivatives done for any commercially reasonable purpose, not just for hedging purposes, as was previous required by the People’s Bank of China.

More significantly, perhaps, for foreign banks wanting to do business in China, qualifying banks with the appropriate licence will now be able to do business onshore. Previously they had to do business either offshore, or through the arms of local Chinese banks. However, there is a caveat: banks wanting to apply for the licence first have to have an onshore branch – a potentially prohibitive requirement for many of the pure investment banks.

Banks line up

Among those that have already applied are HSBC, Citigroup, JP Morgan, BNP Paribas, ABN AMRO and Deutsche Bank.

Along with many others, ABN AMRO is now looking to increase the amount of derivatives experts it has in China, in readiness for what it expects will be a fast-growing market.

James McWilliam, head of derivatives marketing, Asia, for ABN AMRO, says: “The country is definitely an area of major focus for ourselves and our competitors. This is partly because a large percentage of our priority international customers are establishing operations in China, so we need to provide them with a service. We also want to broaden our customer base by offering services to local companies.”

Feng Gao, co-head of global markets for Deutsche Bank in China, says: “All the major banks are now setting up trading desks locally, and are happy and excited about the opportunity in China – it is not just media hype.”

Adding to the sense of excitement generated by the new regulations is the level of sophistication of Chinese derivatives users. Dennis Wan, managing director, head of sales for the credit and rate markets for China and HK region at JP Morgan, says: “Over the last 10 years, the market has been developing at a very fast pace, both in terms of the number and types of end-users of derivatives, and in terms of the number of local banks acting as intermediaries. Already, the market is growing very fast, even though the new regulations have not yet taken effect.”

Speed on the uptake

Mr Wan says the Chinese market already follows international markets very closely, and that once he sees new products emerging in Hong Kong, it is often only a matter of a few weeks or a month before they appear in China. “The level of sophistication here is very high, and managers quickly accept new ideas and structures. I am always impressed by clients’ sophistication level from my regular due diligence process,” he explains.

Mr McWilliam adds: “The onshore corporates tend to be incredibly derivatives-literate and sophisticated – I have no fear for their ability to understand and manage the products they are being, or might be, sold. Like all sophisticated treasurers and risk managers, they have a healthy appetite for derivatives as a means to manage risk.”

There have been some problems, though, even for some of the large all-service banks that have already received approval. According to press reports, in June, just days after receiving its derivatives licence, Citigroup suspended two of its top bankers in China, allegedly for presenting false information to the bank and regulators.

Despite the sense of excitement that the new legislation generated, and embarrassing individual difficulties aside, there are likely to be a whole set of teething problems that will affect all market participants. In particular, even under the new rules, all the coordination of the derivatives markets will still have to be done with separate regulators that supervise the different underlying products. Bankers say that if this situation continues, doing business in China will remain complex, as there are still lots of questions surrounding which regulator should ultimately oversee each product.

Once the new regulations come into effect in September, those banks that have succeeded in gaining approval will face an additional hurdle. Where, until now, they have been doing business in co-operation with local Chinese banks, the latter will suddenly become their direct competitors.

Ready for competition

Mr Wan admits that the competition that will arise between banks like his own and the Chinese firms will present an interesting, if testing, scenario. He says: “The relationships between us have until now been a mutually profitable one. But going forward, we and other foreign banks will be competing head-on with local banks for a stake in corporate business. Different banks are using different strategies to address this.”

Mr Wan says that JP Morgan is positioning itself as a product provider to intermediary banks and is also looking for opportunities within the top tier corporates and investors, and he believes these two will be compatible. He says: “We are managing the situation well and carefully, and are engaging in close dialogue with the local banks so they know what we are doing. Because we don’t aim to take on large sets of corporates as direct counterparts, but only a very targeted segment of the market, the competitive side will be limited.”

TS Cheah, head of Asia (ex-Japan) fixed income derivatives marketing at BNP Paribas, believes those that will face the sternest test will be the Chinese banks. “They have benefited strongly from the closed market and have built up considerable operations, but once foreign banks can deal directly with end customers, they will need to adapt to remain competitive, becoming risk takers and product suppliers, rather than just acting as intermediaries,” he says.

Mr McWilliam, however, believes it is unlikely that the big four Chinese banks (China Construction Bank, Bank of China, Industrial and Commercial Bank of China and Agricultural Bank) will lose much business, as it will take the foreign banks some time to create an equal level of credit comfort.

But aside from competing with local partners, and trying to manage potentially complex relationships with them, foreign banks will also face stiff competition from each other. Those with strong franchises elsewhere in Asia and recognised expertise in derivatives are the most likely to have a head start. That said, each individual bank’s history in China will also play an important role in winning business – and none of those contacted miss the opportunity to stress how long their own bank has been in the country. Mr Wan says: “Long-term commitment is very important. The Chinese have a very long memory and will look back to see [a bank’s] track record.”

Mr Pickel agrees, saying that those participants best placed to participate in the opening-up of the Chinese markets will be those with an existing presence and with well-developed relationships in the region, as well as those with the strongest capabilities in the emerging markets forum.

Waiting game

Even the best-placed banks, however, may need to wait for some time until they gain any lucrative mandates. Mr Pickel says that the speed of growth of the local derivatives market will depend not only on having a sound legal infrastructure with clear guidelines, but also on the information flow to regional market participants about derivatives instruments and their risk management benefits.

Mr Cheah adds: “There will not be a big bang; it will be a gradual evolution, but the serious business will really begin in 2007. The authorities seem to be being proactive and will allow liberalisation and innovation, but between now and 2006, most foreign banks will be busied in establishing their bridgeheads with people and systems. The acid test for the amount of business China is likely to generate will come in 2007.”

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