Bright horizons for Chinese collateral

Speaking at the Euroclear Collateral Conference in November last year, Philippe Dirckx, Head of Fixed Income at ASIFMA said, “Despite China being the second largest economy in the world and having the second largest bond market, the foreign holding of Chinese bonds is still only 3.2%. But there are a number of initiatives and changes in regulation underway that we hope to see materialising soon, and it is very encouraging.”

The need for collateral and funding for Chinese assets is due to the growth in demand from international buyside and sellside firms. Net foreign investment inflows into China were $54 billion in 2017, $85 billion in 2018, $75 billion in 2019 and $130 billion in 2020. Compare this to the ASEAN bond markets that saw a combined $10 billion net outflow in 2020.

This astronomical growth has resulted in China becoming the second largest bond market in the world. Buyside appetite to enter this market is continuing. And, despite challenges such as the sheer cost and operational capabilities required, custodians and other service providers are increasingly confident they can facilitate the financing of transactions in China.

Demand for Chinese securities was boosted in 2020 by their inclusion into global indices provided by FTSE Russell, Dow Jones and MSCI. The business logic of this move is that while foreign holdings in China stand at $450 billion today, index inclusion means they are on track to reach $1 trillion by 2025. At the moment foreign holdings are mainly in Chinese Government Bonds (CGBs) where foreigners already hold 10% of total outstanding CGBs. The Chinese asset class becoming very popular with foreign investors are the policy bank bonds Bank where foreign holdings have shot up to 5% in just a few years due to their better returns and greater liquidity than CGBs.

While these assets classes are in greater demand from foreign investors, some of the underlying issues that market participants face in incorporating these assets into their global collateral pools are being exposed. According to Dirckx, “The inclusion of CGBs in the FTSE Russell index will definitely increase the size of foreign holdings. But seeing a significant change in the availability of these securities for collateral purposes requires seamless access to the market and to hedging and funding tools.”

With investors all around the world having more and more Chinese securities in their portfolios, they are looking for ways maximize their utility. From a collateral giver point of view, they are looking to optimize these securities instead of leaving them in their portfolios and from a collateral taker point of view, investors looking at how they might accept these securities as collateral. The question becomes what changes are needed.

There have been many consultations between the Chinese regulators and Financial Market Infrastructure (FMI) players such as Euroclear, and trade associations such as ISDA and ASIFMA to resolve the issues at hand. The first step in including Chinese securities in the global collateral markets is the increase in underlying investor demand. The second step is for structural collateral takers, such as central banks and CCPs, to make these securities eligible as collateral in their systems. This process is ongoing but market observers believe it is only a matter of time before Chinese securities such as CGBs will become as global and mainstream pieces of collateral as US Treasuries or JGBs.

The third step is to connect the networks that link the givers, takers and securities, and which provide the collateral management services. This includes the Collateral Highway built by Euroclear and DTCC. China Central Depository & Clearing Company, the country’s important FMI has signed an MOU with Euroclear and promote "Both sides agree to promote RMB bonds as common qualified collateral accepted by the UK market" included in the outcomes of the 10th China-UK Economic and Financial Dialogue for CGBs to feature more heavily in the global collateral mix.

“With the reform and opening up of China’s bond market, China’s collateral management ecosystem was developed from scratch,” said Zhang Ting, Head of Collateral Management at CCDC during the Euroclear annual event. “The improving legal environment for China will provide a more solid legal foundation for the use of RMB bond assets.” CCDC now manages Rmb14 trillion of collateral, the majority of which is for use onshore. It has agreements with five Chinese futures exchanges whereby CGBs can be used as margin for futures trading. This volume has increased from Rmb20 million a month to Rmb21 billion in just the last few years. International growth has been less quick. However, by September 2020, Rmb40 billion of CGBs were already in use for cross border collateral, according to Ms Zhang.

There is still some way to go before the legality on issues such as netting, clear out and bankruptcy resolutions are fully clarified, and these are still big hurdles for international firms. Two other issues around currency controls and the fungibility of assets also present problems. China is not likely to mirror international standards. And it still has to be seen how critical components in China, such as capital controls, will work in cross-border financing.

While hurdles such as these are daunting, the sheer size of the opportunity is too great for large financial institutions to ignore. Exposure to China remains one of the key areas of focus for everyone working in APAC. The recent enhancement to QFII - while opening up opportunities across futures, margin finance and lending - is likely to further complicate an already complex landscape.

Firms, such as large asset management companies, can now hold Chinese assets domestically, through the Stock Connect channel and via their QFII allocation. However, while there are some commonalities across these channels, they are very separate pools of assets with different considerations and no fungibility. The opportunities may be considerable, but there's still a lot for firms to get their head around.

Investor demand is rising both for Chinese securities and for their inclusion in the global collateral mix. CCPs and central banks as structural collateral takers, need to make these securities eligible as collateral in their systems. All the work being done by FMIs such as Euroclear to connect collateral givers and takers, will then really come to life. And China will then take its rightful place at the heart of the global collateral markets.