In China, banks chafe at derivatives drive
By Eadie Chen and Jonathan Leff
BEIJING/SINGAPORE, July 27 (Reuters) – While Washington pursues a high-profile overhaul of its derivatives markets, a more modest but equally important crackdown is underway in China.
After a series of corporate commodity and forex hedging deals went spectacularly bad over the past 9 months, costing state-linked enterprises billions of dollars, Beijing stepped in with new limitations to improve transparency and attempt to prevent speculative bets.
In the latest measure, imposed earlier this month, the State-owned Assets Supervision and Administration Commission (SASAC) that has led this drive ordered all central government-controlled companies engaged in trading derivatives to make quarterly reports about their investment situations.
While a far cry from the sweeping changes happening in the United States — where weekly position reporting is the norm and regulators are trying to limit speculative activity rather than corporate risk management — it’s no less noteworthy.
For investment banks looking harder than ever for less risky ways to fuel profit growth, the expansive Chinese risk management business is an alluring prospect; for Chinese corporations engaged in multibillion-dollar overseas acquisitions and importing record volumes of raw materials, the need to buy protection from volatile market prices is equally high.
For the moment, however, that business is a hard sell.
“The market has already seen hedging business from China sharply drop this year, and this new rule is bad news for investment banks that are traditionally treating China as their top-tier growth market,” said Daniel Liu, a Singapore-based energy strategist at major commodity broker MF Global.
But it’s not one easily given up.
Goldman Sachs, the world’s biggest commodity derivatives trader, has maintained its China business even after the departure of several key marketers working from Beijing and a months-long dispute with a power plant in southern China that had attempted to back out of an oil price hedge last year.
It has recently hired Singapore-based veteran energy marketer Jeffrey Chen from Barclays Capital, market sources say.
The message is clear from Beijing, which has been forced to bail out bad derivatives deals for over 15 years, from oil traders reneging on forex hedges in the 1990s to wrong-way bets on metals prices to China Aviation Oil’s $550 million speculative options debacle to the latest round of heavy losses.
“We encourage state firms to enhance their industrial businesses and sharpen their competitive edge in the international industrial world, not the deep-water financial market,” Kuang Yongsheng, an official from SASAC said.
“We don’t want to see them diverge their core businesses to speculate in the financial market.”
UNFORTUNATE BUT PREDICTABLE
The backlash against derivatives is unfortunate but predictable, say industry officials, as a few badly structured or overly risky deals overshadowed the many conservative hedges undertaken by other companies — which often cost more up front, but provide greater protection or flexibility if markets change.
A handful of companies racked up eye-popping losses as forex markets gyrated and commodity prices plummeted late last year.
Some were just bad luck: three airlines booked nearly $2 billion in jet fuel hedging losses as prices plunged; others were the act of overzealous managers: CITIC Pacific lost $2 billion on unauthorised leveraged forex trades.
As a result, managers are shunning even straightforward risk deals that might make good sense to their core business, and have completely abandoned the more complex products that lured other companies like knock-in, knock-out structures, which can pay dividends in a stable market but turn toxic with volatility.
“Pure speculation is very rare for us. We have no need at all to run any big risks. If you make money, nobody will praise you. But if you lose money, you are in big trouble,” an executive from a central state metal firm told Reuters.
“The financial crisis, all those scandals, and the new government rule make us even more unwilling to trade sophisticated products. People will turn pale even at the mention of exotic tools,” he said.
As elsewhere, China’s reaction to the industry turmoil has been to retreat to the relative safety of exchange-traded instruments or hedges that allow for physical delivery, such as forwards — both of which can help sidestep restrictions.
“They’re a huge consumer, and the companies are still carrying those price risks, and they still need to manage those risks,” said one senior commodities banker.
BATTLE FOR BUSINESS
Industry officials in China say the mood at the moment is an overreaction, and believe Chinese firms will come back after the pain is forgotten — whether that’s in six months or two years is an open question, however, and in the meantime it’s a battle for established brands to defend and rebuild their franchise.
The pressure is from both directions: foreign banks that did not do business with Chinese state firms last year and are therefore untroubled by the latest backlash are rapidly making in-roads, such as Standard Chartered.
“Trading volume will further decline, and banks have to go for less-credit-worthy and non-state-owned Chinese companies for new business, and have to increase risk appetite if they decide to do business with China clients at all,” MF Global’s Liu said.
Domestic banks are also growing their risk capabilities, with the Agricultural Bank of China moving to set up trading desks in New York and London for a 24-hour operation.
But authorities are now vigilant here as well.
A banking regulator told Reuters that the China Banking Regulatory Commission would soon issue rules similar to that from the SASAC to better supervise derivatives trading by commercial banks under its mandate.
“It is indeed an opportunity for Chinese banks to expand business. But I think the chances for Chinese banks to replace foreign banks in the market is very slim. They are too young and too inexperienced,” said the regulator, who declined to be named. (Reporting by Eadie Chen and Jonathan Leff; Editing by Michael Urquhart)