20141218 Demystifying the Myths of Credit Derivatives in ......Chaori bond defaulted earlier this...

Demystifying the Myths of Credit Derivatives in China

张海云

Henry Haiyun Zhang, Ph.D., FRMDirector, UIBE Financial Markets Institute (FMI), ( )Professor, UIBE School of Banking and Finance (SBF)Co-Director, Beijing Chapter, Global Association of Risk Professionals (GARP)December 18, 2014

The views expressed in the following material are the

author’s and do not necessarily represent the views of

th Gl b l A i ti f Ri k P f i l (GARP)the Global Association of Risk Professionals (GARP),

its Membership or its Management.

2

Introduction

The myth of implicit guarantee

The myth of capital reliefThe myth of capital relief

The myth of risk prevention

Conclusion

3 | © 2014 Global Association of Risk Professionals. All rights reserved.Financial Markets Institute Haiyun Zhang

Credit Risk Mitigation products:The CDS of ChinaThe CDS of China

In late 2010, China unveiled its onshore credit derivatives market with the launch of twoIn late 2010, China unveiled its onshore credit derivatives market with the launch of two products: CRMA and CRMW. With respect to underlying obligations, China’s CRM products adopted the “specific underlying obligation” feature and rejected the standard category-based feature in international CDS markets. This simplification in product d i h il d i Chi j i tidesign was hailed in China as a major innovation.

Credit Risk Mitigation Agreement (CRMA) Credit Risk Mitigation Warrant (CRMW)

• Bilateral contracts between two counterparties similar to CDS contracts

• Reference asset must be either a

• Credit enhancement contracts on publicly traded debt, sold by qualified financial institutions, and freely tradable like securities• Reference asset must be either a

bond or a loan• Each contract can provide protection

only on a specific bond or loan rather

securities• Standard market operating workflow like in

the bond market, complete with application & registration, issuance & only on a specific bond or loan rather

than a class of debt, a feature that differs from standard CDS contracts in international markets

distribution, and trading & settlement, etc. • Each contract can provide protection only

on a specific traded debt


Credit hedging in China:A multi trillion dollar potential marketA multi-trillion dollar potential market

Huge and Rapidly Growing Demand for Credit HedgeHuge and Rapidly Growing Demand for Credit Hedge

Source: PBOC, China Bond, UIBE Financial Markets Institute

Compounded Annual Growth Rate (CAGR) over the last decade:•16% for loans outstanding•52% for credit bonds outstanding


The CRM market:Anemic since inceptionAnemic since inception

2010 2011 2012 2013 T l2010 Launch 2011 2012 2013 Total

CRMA: Transaction Count 23 10 13 0 46

CRMA: Transaction Amount (CNY MM) 1,990 610 1,340 0 3,940

CRMW: New Issue Count 8 1 0 0 9CRMW: New Issue Count 8 1 0 0 9

CRMW: New Issue Amount (CNY MM) 690 50 0 0 740

CRMA + CRMW: Count 31 11 13 0 55

CRMA + CRMW: Amount 2 680 660 1 340 0 4 680(CNY MM) 2,680 660 1,340 0 4,680

•Cumulative transaction amount since inception is less than 0.01% of potential market•No new transactions in 2013


Global credit derivatives market in early years:Rapid growthRapid growth


The CDS product:An event driven derivative productAn event driven derivative product

1. What Types of Credit Events?

P t ti P t ti

Before default and CDS maturityyp

Types in 2003 ISDA Definitions:•Bankruptcy•Failure to pay

ProtectionBuyer

ProtectionSeller

ProtectionPremiums

p y•Restructuring•Obligation acceleration•Obligation defaultRepudiation / Moratorium

If default (credit event) happens b f CDS t it

•Repudiation / MoratoriumAdditional Type in 2014 ISDA Definitions (went live in September 2014 ):

•Bail-in

Protection ProtectionDefault

before CDS maturity2. What to Do Following Credit Events?How to determine defaults?H t k ttl t ?Protection

Buyer Protection

Seller Default

Payment

3. Whose Credit Events?

How to make settlements?Which obligations are deliverable?


The CDS product:Much ado about “Obligations”Much ado about Obligations

•Marks the minimum seniority ofWhich obligation should be cited in the CDS term sheet?

Reference Obligation

•Marks the minimum seniority of deliverable obligations•Often a large & liquid bond issue for CDS•Syndicated secured loan for LCDS

Obligations(“Event Obligations” or “Default Obligations”)

Which obligations can trigger credit event?

Criteria:•Obligation Category•Obligation Characteristics

Which obligations DeliverableCriteria:D li bl Obli ti C tWhich obligations can be delivered for

physical settlement?

DeliverableObligations

•Deliverable Obligation Category•Deliverable Obligation Characteristics


Event Obligation:Category TypesCategory Types

Event Obligation North American Breadth ofEvent ObligationCategory

North American Corporate CDS

Market Standard

Breadth of Category Scope

PaymentPayment

Borrowed Money √Bond or Loan

Bond

Loan

Reference obligations only

Borrowed Money (2003 ISDA Definitions, 2.19 (a) (ii)):y ( , ( ) ( ))Any Obligation (excluding undrawn revolving credit arrangements for which there are no outstanding, unpaid drawings in respect of principal) for the payment or repayment of Borrowed Money


Deliverable Obligations:Types of CharacteristicsTypes of Characteristics

Deliverable Obligations North American Corporate CDSDeliverable Obligations Characteristics

North American Corporate CDS Market Standard

Not Subordinated √√Specified Currency √

Not Contingent √

Assignable Loan √Assignable Loan √

Consent Required Loan √

Transferable √

Max Maturity 30 Y √

Not Bearer √

Not Domestic IssuanceNot Domestic Issuance

Not Domestic Law

Not Sovereign Lender


The CDS product:Protection covers a category of obligationsProtection covers a category of obligations

Loan A Loan B

The reference entity’sobligations include:

CDS Reference Obligation:Often a large & liquid bond issue

Suppose:

Bond CSenior Unsecured

Senior Secured Senior Secured


Bond ESubordinated

Event Obligations Deliverable ObligationsIn a standard

Loan ASenior Secured

Loan BSenior Secured

g g



Corporate CDS in North America


Bond ESubordinated



The CRM products:Protection covers a specific obligationProtection covers a specific obligation

•Among the Obligations (“Event Obligations”) Categories you can also chooseAmong the Obligations ( Event Obligations ) Categories, you can also choose “Reference Obligations Only”, but this is not the CDS market standard.•CRM’s “Specific Obligation” feature is equivalent to selecting the “Reference Obligations Only” in CDS.

Loan A Loan B

The reference entity’sobligations include:

CDS Reference Obligation:Often a large & liquid bond issue

Suppose:





Bond DSubordinated

In a “Reference Obligation Only” CDS

Event Obligations Deliverable Obligations




The stalemate of China’s CRM market:What are the problem areas?What are the problem areas?

Hurdle Areas Cited Root Causes of The Market’s StalemateInstitutionalhurdles

Many blame the market’s stalemate on unaccommodating rules, regulations, laws and other institutional constraints.

Credit hurdles Many think that the lack of material default losses in China’s bond market has hitherto rendered credit hedging unnecessary.

Analytical hurdles

Many attribute the market’s stalemate to difficulties in risk and valuation analysis associated with accessibility and quality of data and models.

P S th iti i th i fl ibilit f th CRM d t t t MProduct hurdles Some authors criticize the inflexibility of the CRM product structure. My articles show that CRM’s “specific underlying obligation” feature defeats the product’s purpose of risk mitigation and capital relief when used for loan hedging.


The stalemate of China’s CRM market:Views on root cause & growth impedimentsViews on root cause & growth impediments

Institutional Credit Analytical ProductInstitutionalhurdles

Credit hurdles

Analytical hurdles

Product hurdles

M j M th th Regulatory ImplicitMajor Myths on the Bottleneck

Regulatory capital

Implicit guarantee

Participationb i

Other Conjectures on Growth

barriers

Peripheral rules

Analytical difficulties

Inflexible structure

ImpedimentsMarket mechanisms

True Bottleneck in My View

Product alteration


Myths and misunderstandings in China:Three major areas in credit derivativesThree major areas in credit derivatives

Wh ’What’s deadlocking the

market?•The myth of implicit guarantee•The myth of capital relief

Do credit derivatives

Is the product alteration derivatives

have a future?alteration

beneficial?

•The myth of risk prevention •The myth of CDS prospect


y p y p p

Introduction




Conclusion


China's first onshore bond default:Chaori bond defaulted earlier this yearChaori bond defaulted earlier this year

Shanghai Chaori in Default on Bond Interest PaymentsSolar-Equipment Maker Becomes China's First Domestic Corporate-Bond Default

By LINGLING WEI, Wall Street JournalUpdated March 6, 2014 11:50 p.m. ET

So far, the Chinese government and state-owned banks have largely kept risky borrowers afloat by providing bailouts or debt extensions, keeping borrowing costs y p g p g glow for companies with high debt.As of the end of June, the most recent period for which such data are available, Chaori had failed to pay 12 banks almost 1.5 billion yuan of loans on time.


Bailout of China's first onshore bond defaultsignals continued implicit guarantee for bondssignals continued implicit guarantee for bonds

Chaori bailout shows Beijing's desire to protect bond marketBY CHARLIE ZHU AND UMESH DESAI, Reuters

Oct 9, 2014

The bailout of domestic bondholders of Chinese solar equipment producer Chaorishows the government is determined to shield its rapidly growing corporate bond market in a slowing economy, analysts and traders say.Shanghai Chaori Solar Energy Science and Technology Co Ltd , which missed an interest payment on its bond in March, announced on Tuesday that nine domestic companies, including Jiangsu Golden Concord, will form a joint venture to invest in th i d bt t t ithe company in a debt restructuring.State-owned China Great Wall Asset Management and a Shanghai-based investment firm will also guarantee 880 million yuan of the one billion yuan worth of bond issued by Chaori in 2012 and traded on the Chinese securities market thebond issued by Chaori in 2012 and traded on the Chinese securities market, the company said.


Implicit guarantee for bonds:Root cause of the CRM stalemate?Root cause of the CRM stalemate?

No default losses Credit protection Implicit Guarantee No default losses for bondsp

on bonds is worthless

The Myth of Implicit Guarantee:y pImplicit guarantee for bonds is the root cause of the CRM stalemate.

Logic:Implicit guarantee for bonds leads to the absence of default losses for bonds, and thereby destroys the value of credit protection referencing bonds.


The myth of implicit guarantee:What’s the missing link?What s the missing link?

The Myth of Implicit Guarantee:Implicit guarantee for bonds is the root cause of the CRM stalemate.

The Missing Link: What about loan hedging?The Missing Link: What about loan hedging?In China loans comprise the lion share of credit assets. Unlike bonds, default losses on bank loans have been material and non-performing loans have been on the rise over the past two years. CRM was rolled out mainly to meet loan hedging needs.


The myth of implicit guarantee:The puzzle of CRM and loan hedgingThe puzzle of CRM and loan hedging


Questions:1. How does the implicit guarantee for bonds affect CRM hedging for loans?

It renders the CRM loan hedging useless if the CRM references bonds. It has no impact on the CRM loan hedging if the CRM references loans It has no impact on the CRM loan hedging if the CRM references loans.

2. How do we interpret the CRM market’s languor despite the rising need for loan hedging? A likely cause is that the protection sellers and / or buyers are disinclined

to use loans as reference obligations.3. Will the international standard CDS meet the loan hedging needs given the

above situation? Even for protection referencing bonds the category-based feature in the Even for protection referencing bonds, the category-based feature in the

international standard CDS product would still cover loan defaults.


The myth of implicit guarantee:Loan hedging in CRM versus CDSLoan hedging in CRM versus CDS

Obligor’s Bank Asset Credit Protection





gSenior Obligations To Be Hedged Reference Obligation

Relevant obligations


Bond DSenior Unsecured

Loan AS i S d

Loan BS i S d

Market Standard CDSCovers All Obligations in a Category

China’s CRMCovers Reference Obligation Only

Obligations covered by credit protection





If default occurs on Loan ABut not on Bond C

Bank is entitled tocredit protection payment

Bank is NOT entitled tocredit protection payment


The myth of implicit guarantee: The crux of loan hedging ineffectivenessThe crux of loan hedging ineffectiveness


International standard CDS remains effective in loan hedging despite implicit bond guarantee1. Implicit guarantee for bonds is a link in the causal chain of the CRM stalemate

b t not its root ca sebut not its root cause.2. The failure of CRM’s rise to meet the loan hedging needs for Chinese banks

reflects the banks’ disinclination to use their loans as reference obligations, making bonds the reference obligations of choice. It is in this context that the g gimplicit guarantee for bonds renders CRM hedging ineffective. Note that the implicit guarantee for bonds will not diminish the loan hedging effectiveness in standard CDS in international markets.

3 This deadlock is a by product of CRM’s rejection of the standard category3. This deadlock is a by-product of CRM s rejection of the standard category-based feature in international CDS markets.

4. The root cause of the stalemate is therefore the CRM product alteration on underlying obligations, which has been hailed as an innovation in China.


y g g ,

The myth of implicit guarantee: What if the implicit guarantee goes away?What if the implicit guarantee goes away?


Ending implicit bond guarantee will not make CRM loan hedging effective

1. Ending implicit bond guarantee opens the door for bond default losses.2 H b d d t t ti ll d f lt h th b ’ l d f lt2. However, bonds do not automatically default when the borrower’s loan defaults.3. Therefore, CRM remains ineffective for loan hedging purposes.


Credit hedging in China:The Who What and HowThe Who, What and How

Observations ConclusionsObservations Conclusions•Loans outstanding is currently 10 times the size of credit bonds outstanding•The bond market’s first actual default

•There is significant demand for hedging loans but not bonds•Demand for hedging comes mainly

happened in March 2014 but was bailed out a few months later•Banks are the largest holders of bonds

g g yfrom banks

•Most loans in China are bilateral and have no market visibility

•It would be difficult for the broad market to embrace those obscure loans as reference obligations

Recap:Recap:•In China, until recently the product’s usefulness has been limited to helping banks(Who) hedge their loan exposures (What)Th t b d d f lt d t t i ll h thi i t i t t di•The recent bond default does not materially change this picture since outstanding

credit exposures mostly reside within the loan sector•To develop a broad following, credit protection should reference well known bonds (How) rather than obscure bilateral loans


bonds (How) rather than obscure bilateral loans

Introduction




Conclusion


Lack of recognition for regulatory capital relief:Root cause of the CRM stalemate?Root cause of the CRM stalemate?

CRM protection has yet to win banking regulatory approval for capitalCRM protection has yet to win banking regulatory approval for capital relief. This has been cited as a foremost obstacle to CRM market development.

The Myth of Capital Relief:The lack of recognition for the capital relief function of CRM protection is the root cause of the CRM stalemate.

Logic:1. Banks are motivated to hedge loan exposures not only to reduce and diversify

credit risk but also to gain regulatory capital relief. 2. The lack of recognition for regulatory capital relief is therefore a major reason

why banks have not been enthusiastic about buying CRM protection.3 The “China OTC Derivatives Market Annual Report 2012” by the National3. The China OTC Derivatives Market Annual Report 2012 by the National

Association of Financial Markets Institutional Investors (NAFMII) stated that the number one priority for the CRM market development is facilitating the explicit regulatory recognition of CRM’s capital relief function.


The myth of capital relief:What’s the missing link?What s the missing link?

The Myth of Capital Relief:The lack of recognition for the capital relief function of CRM protection is the root cause of the CRM stalemate.

The Missing Link: Is capital relief justified for CRM protection on loans?

The capital relief function of standard CDS protection is well established globally because CDS protection is effective in offsetting the risk of the underlying assets.

C C SDue to the CRM product alteration, the regulatory capital treatment on CDS may no longer be applicable to CRM.The CRM product alteration diminishes CRM’s hedging effectiveness and could invalidate capital reliefinvalidate capital relief. The CRM product alteration should be examined in the context of both risk analysis and capital requirements.


The myth of capital relief:Loan hedging in CRM versus CDSLoan hedging in CRM versus CDS






gSenior Obligations To Be Hedged Reference ObligationRelevant obligations



Obligations covered by credit protection Loan A

S i S dLoan B

S i S d






Bond CSenior UnsecuredPrevention of this scenario

depends on cross-default or cross-acceleration clause between Bond C

If default occurs on Loan ABut not on Bond C

Bank is entitled tocredit protection payment

Bank is NOT entitled tocredit protection payment

and Loan A


The myth of capital relief:When should credit protection bring relief?When should credit protection bring relief?

The Myth of Capital Relief:The Myth of Capital Relief:The lack of recognition for the capital relief function of CRM protection is the root cause of the CRM stalemate.

•Basel II, 162 (Additional operational requirements for credit derivatives)•(b): If the credit derivative covers obligations that do not include the underlying obligation, section (g) below governs whether the asset mismatch is permissible•(g): A mismatch between the underlying obligation and the reference obligation under the(g): A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (1) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i e the same legal entity) and legally enforceable cross default orshare the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.•(h): A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (1) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.

•Chinese bank capital requirements are the same as the above.


Chinese bank capital requirements are the same as the above.

The myth of capital relief: Interpretation of capital relief criteriaInterpretation of capital relief criteria

Yes

Capital Relief

D th dit No Is the underlyingDoes a default on the

d l i bli tiYes

Yes

Does the credit protection cover the underlying obligation?

No

Yes

Is the underlying obligation not subordinate to the reference obligation?

underlying obligation cause cross-default or cross-accelerate in the reference obligation?

Yes

No

reference obligation?

No

No Capital Relief


The myth of capital relief: CRM versus international standard CDSCRM versus international standard CDS

Yes

Capital Relief

D th dit No I th l tDoes a default on the lYesDoes the credit

protection cover the loan to be hedged?

No

Yes

Is the loan not subordinate to the reference bond?

loan cause cross-default or cross-accelerate in the reference bond?

Yes

reference bond?

NoCRM (China)

No Capital Relief

( )

CDS (International Standard)


The myth of capital relief: Capital relief for offsetting a loan exposure?Capital relief for offsetting a loan exposure?






gSenior Obligations To Be Hedged Reference Obligation

Relevant obligations



Does the credit protection cover Loan A? Yes No



cover Loan A?

Will default on Loan Atrigger cross-default or cross acceleration in Bond C?

Nocross-acceleration in Bond C?

Yes NoShould the credit protection be recognized for capital relief against Loan A?


g

Introduction




Conclusion


CRM product alteration:Does it facilitate risk prevention?Does it facilitate risk prevention?

信用风险缓释工具（CRM）中国信用衍生产品信用风险缓释工具（CRM）参与主体多元化相关问题研究

中国银行间市场交易商协会2012年6月

中国信用衍生产品创新与发展问题研究中国银行间市场交易商协会

2010年7月

CRM使每笔交易合约都与具体债务对应，在交易结构上比国际通行的CDS更加简单明了，充分体现了标的债务的‘穿透性’

虽然指定标的债务在一定程度会影响市场参与者的交易效率，但在信用事件处理上会更加简单，也更容易判断市场参与者的

原则。真实交易意图，有利于市场风险防范。

A widely held view is that altering the CDS product’s Obligation feature helps containing risk by improving transparencycontaining risk by improving transparency. The Myth of Risk Prevention:The CRM’s alteration of the Obligation feature facilitates risk prevention.

The Logic:This alteration makes it easier for regulators to gauge market players’ trading intentions


intentions.

The myth of risk prevention:What’s the missing link?What s the missing link?

The Myth of Risk Prevention:The CRM’s alteration of the Obligation feature facilitates risk prevention.

The Missing Link: What about the CRM product alteration’s unintended consequences?

If a transaction lays bare a market player’s trading intentions, the player may choose to stay away from the transaction. This may well be a key reason why the market has hitherto given cold shoulder to CRM.gA serious consequence of the CRM product alteration is that it fragments the credit protection market. This fragmentation hinders price discovery and obscures price visibility. Since credit protection prices are important indicators of risk levels theSince credit protection prices are important indicators of risk levels, the fragmentation resulting from the CRM product alteration hampers regulators’ risk monitoring and risk prevention efforts.


The myth of risk prevention:Alteration causing market fragmentationAlteration causing market fragmentation

B d A4 (8Y)B d A3 (5Y)B d A1 (1Y) B d A2 (3Y)Firm A’s Relevant Bond A4 (8Y)$200 MM

Bond A3 (5Y)$300 MM

Bond A1 (1Y)$200 MM

Bond A2 (3Y)$400 MM

Firm A s RelevantObligations

Market Standard CDS China’s CRM

Credit ProtectionFamilies

Covers All Obligations in a Category

One CDS FamilyCDS A

Covers Reference Obligations Only

Four CRM FamiliesCRM A1, CRM A2, CRM A3, CRM A4

CDS A Covers $1,100 MM Obligations

Bond A1 (1Y)$200 MMCRM A1 Covers

Credit ProtectionCoverage Bond A1 (1Y)

$200 MMBond A2 (3Y)

$400 MM

Bond A2 (3Y)$400 MM

Bond A3 (5Y)$300 MM

CRM A2 Covers

CRM A3 CoversBond A3 (5Y)

$300 MMBond A4 (8Y)

$200 MM

$300 MM

Bond A4 (8Y)$200 MMCRM A4 Covers


Introduction




Conclusion


Myths and misunderstandings in China:Three major areas in credit derivativesThree major areas in credit derivatives

•The myth of implicit guaranteeWhat’s deadlocking

the market?

The myth of implicit guarantee•The myth of capital relief My view: The CRM product alteration is the real bottleneck

Do credit derivatives have a future?

Is the product alteration beneficial?

•The myth of risk preventionMy view: The CRM product alteration hinders risk prevention

•The myth of CDS prospectMy view: CDS has a key place in the financial value chain


My answers to key three questions

1. Should China develop a home-grown creditderivatives market?• The answer is Yes

2. How do we end the CRM stalemate?• Reject the CRM product alteration• Restore the standard international CDS structure

3 Will a restoration of the standard international3. Will a restoration of the standard international CDS structure hinder risk prevention?• No Actually restoring the standard internationalNo. Actually restoring the standard international

CDS structure is good for risk prevention


Financial Markets InstituteU i it f I t ti l B i d E iUniversity of International Business and Economics

F d d i 1951 th B iji I tit t f F i T d th U i it f• Founded in 1951 as the Beijing Institute of Foreign Trade, the University of International Business and Economics (UIBE) has grown to become one of China’s best and most internationalized universities in business and finance, benefitting greatly from the explosive growth over the past three decades of China’s marketgreatly from the explosive growth over the past three decades of China s market economy and foreign trade.

• The UIBE Financial Markets Institute was founded in late 2009. The Institute’s founding Director Professor Haiyun Zhang is also a Co Director of the Beijingfounding Director, Professor Haiyun Zhang, is also a Co‐Director of the Beijing Chapter of Global Association of Risk Professionals (GARP). Professor Zhang brings rich industry experience, having worked in trading, structuring, risk management and quantitative analysis at global financial firms such as Merrillmanagement and quantitative analysis at global financial firms such as Merrill Lynch, TD Bank, and Bank of America. The Financial Markets Institute aims to conduct applied research in financial markets, provide actionable insights to financial industry players foster collaboration with financial institutions andfinancial industry players, foster collaboration with financial institutions, and promote exchanges among professionals in the financial industry and the academia.


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20141218 Demystifying the Myths of Credit Derivatives in ......Chaori bond defaulted earlier this...

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