By Zhang Yashuang, Head of Research & Statistics Department, Shanghai Clearing House, and Ricco Zhang, Director, Asia Pacific, ICMA
In October 2018, the People’s Bank of China announced that it will launch triparty repo in China’s interbank bond market. Shanghai Clearing House (SHCH) plans to launch General Collateral (GC) repo transactions in cooperation with China Foreign Exchange Trade System (CFETS), the trading platform for China’s interbank bond market. As a qualified central counterparty (CCP) and a central securities depository (CSD) recognized by the People’s Bank of China, SHCH will be responsible for providing CCP clearing services and collateral management services for GC repo transactions.
China’s bond repo markets
China’s bond repo market includes two types of repo, under pledge and title transfer arrangements, and is comprised of two trading venues, the interbank bond market and the exchange bond market. Pledged repo and the interbank bond market are the largest components. In 2018, the trading volume of repo transactions in China’s bond market amounted to RMB986 trillion (USD141 trillion), of which pledged repo accounted for 98%.
The interbank bond market repo accounted for 77%. The interbank market operates with two CSDs offering two transaction settlement mechanisms. SHCH, as one of the CSDs (and the only CCP) for the interbank market, provides either gross trade-by-trade clearing and settlement, or CCP clearing. The other CSD for the interbank market, China Central Depository & Clearing Co., Ltd. (known as CCDC), provides gross trade-by-trade clearing and settlement services for trading participants.
Repo transactions in the exchange bond market include three types: “standard” bond repo, agreement repo and triparty repo. Standard bond repo uses anonymous bidding and a CCP clearing mechanism, and allows individual investors to participate as the reverse repo party. Agreement repo uses bilateral price inquiry and a gross trade-by-trade clearing and settlement mechanism. The main difference between triparty repo and agreement repo is that the China Securities Depository & Clearing Co., Ltd. (known as CSDC), as the CSD for the exchange bond market, provides specialized collateral management services for triparty repo transactions.
Following the People’s Bank of China’s announcement, SHCH and CCDC will cooperate with CFETS to launch triparty repos in the interbank market. In the future, repo transactions in China’s interbank bond market will demonstrate a diversified landscape, including GC repo, triparty repos based on gross trade-by-trade clearing and settlement mode, bilateral repos with CCP clearing, as well as bilateral repos based on gross trade-by-trade clearing and settlement mode.
China interbank market triparty repo mechanisms
GC repo1 is a triparty repo which adopts a CCP clearing mechanism. In a GC repo transaction, a financing repo party submits eligible bonds as collateral to its special pledge account at SHCH. SHCH then calculates the repo quota for the financing repo party and transfers the information to CFETS on a daily basis. GC repo transactions are carried out within the limit of the repo quota. SHCH provides collateral management and CCP clearing services for the trading participants. The market includes several mechanisms to facilitate operational efficiency, including:
- Special pledge accounts. SHCH opens a special pledge account for each GC repo investor and maintains a oneto-one correspondence with its original bond account. The investor can transfer the bonds of the bond account into or out of the pledge account through the client system of CFETS or SHCH.
- Calculation of repo quota. The value of bonds in each special pledge account is converted into a corresponding value of general collateral according to specified algorithms, and the repo quota is calculated based on the value of general collateral for each pledge account.
- Confirmation of repo quota. When a financing repo party initiates a GC repo transaction in the business system of CFETS, the due settlement amount of the transaction shall be checked not to be higher than the repo quota of the financing repo party, so as to make sure that the amount of collateral is sufficient.
- Collateral matching and mark-to-market. SHCH selects the pledged bonds from the special pledge account to complete the match, so as to maintain the one-to-one correspondence and sufficient pledge between each transaction and the pledged bonds. In the duration of the transaction, the value of the pledged bonds is marked-to-market daily so as to detect possible arrears, and the financing repo party shall be required to submit additional collateral so as to make up for the shortfall in pledge value.
SHCH acts as the CCP for GC repo and takes on delivery risk after novation in order to ensure safety of the repo transaction; in addition, SHCH also acts as a CSD for GC repo and provides specialized collateral management services.
Risk management mechanisms
GC repo has designed several risk prevention mechanisms to effectively identify, monitor and prevent the risk of pledged bonds. The clearing members of SHCH, which are selected prudently, are the first line of defence for counterparty credit risk. In addition to setting the scope and corresponding haircut, SHCH also sets differentiated discount rates for special pledge accounts according to creditworthiness of a specific clearing member in order to control leverage levels. Qualified institutional investors that are not clearing members can only participate in GC repo through one of the clearing members.
As now extended to the interbank bond market, GC repo has also made many specific mechanism innovations. For example, first, GC repo adopts a DVP delivery mechanism. Second, legal correspondence between each repo transaction and its pledged bond is clear, which avoids legal uncertainty in case of default disposal. Last but not least, repo rates in the interbank market are prominent as benchmark rates in terms of acceptance, functions and characteristics, and extreme abnormal rates are very rare. Also, in terms of business process, SHCH will cooperate with CFETS to conduct real time novation in GC repos, to facilitate smooth transition between pre-trade and posttrade segments.
Overseas institutional investor participation in GC repo transactions
At present, overseas investors, central banks, sovereign wealth funds, as well as RMB clearing banks and participating banks, are eligible to participate in China’s interbank bond repo transactions. If these investors are bond CCP clearing members of SHCH, they can apply to participate in GC repo transactions directly. If they are not clearing members, they can participate in an indirect way as clients through general clearing members. With the further opening up of China’s bond market and the improvement of market arrangements, it is expected that more types of overseas investors will be eligible to participate in China’s bond repo market and in GC repo transactions at an appropriate time.
This article also appeared in the ICMA Quarterly Report, published on October 10, 2019.