Low heat likely as China stews on derivative losses - By Eadie Chen and Tom Miles

<blockquote>"But the definition of a "hedge" is often open to interpretation, particularly on deals that are more complex, and it remains unclear how Beijing will address that distinction in the often chaotic and opaque industry.


No concrete rules cover the over-the-counter (OTC) market and derivatives trading. Although only 31 state firms are authorized to trade derivatives abroad, many others manage to do so by taking advantage of obscure rules and the regulatory overlap between the state asset watchdog and the securities regulator."</blockquote>


Low heat likely as China stews on derivative losses

By Eadie Chen and Tom Miles - Analysis
Tue Sep 29, 2009
Source

BEIJING (Reuters) - A Chinese saying nicely sums up the likely fallout from this summer's tussle between state firms and foreign banks over toxic derivative deals: "When the thunder is big, the rain is small."

Optimists hope the threat of state-sanctioned contractual defaults may finally force Beijing to provide clearer guidelines on what types of contracts it will allow, helping unfreeze activity in one of the fastest growing markets for risk managers.

Pessimists fear the lack of clarity may continue indefinitely, casting a pall over anything but the most vanilla trades, limiting banks' profits and possibly leaving those same state enterprises increasingly exposed to global prices.

But on one point both concur: there is precious little chance of the conflict spilling into open warfare, which would put at risk Beijing's reputation as an open, fair financial player that respects contracts, and would force banks to damage relationships with some of their biggest clients by launching lawsuits.

"There is no indication that the parties involved will go to court or arbitration tribunal to resolve the issue. It is very likely that they will renegotiate their contracts," said Yang Tiecheng, a Beijing-based senior lawyer focusing on derivative issues at global law firm Clifford Chance LLP.

The China State-owned Assets Supervision and Administration (SASAC) earlier this month gave an apparent state sanction for companies to back out of loss-making deals, confirming reports that it may allow state firms to default on some of their oil options trades and even take legal action to minimize losses.

For their part, the banks involved -- believed to include industry heavyweights like Goldman Sachs Group (GS.N), UBS (UBSN.VX), JP Morgan (JPM.N), Citigroup (C.N), Morgan Stanley (MS.N) and Deutsche Bank (DBKGn.DE) -- have maintained a resolute silence, hoping to avoid the kind of confrontation that could jeopardize business in the world's third-largest economy.

"I think the two parties will not ruin their big pie because of the small pie," a Singapore-based investment banker said, adding that there was a growing cadre of up-and-coming banks eager to break into the Chinese market if the top-tier players lose their early-mover edge.

"This is an unprecedented chance as China sees the greatest growth of hedging business in the whole world," the banker said.

As none of the details of the contracts have been revealed, no one can examine which side is on a more solid footing, or even say how much money is at stake.

The state airliners, which have most often been cited as those still paying out loss-making hedges, reported book losses totaling 13.17 billion yuan ($1.94 billion) as of the end of January on aviation fuel hedging contracts.

At dispute are contracts that offered the allure of low up-front costs and even income in calm or rising markets, but led quickly to mounting losses as prices plunged suddenly last year.

WASHINGTON IN REVERSE

In an inverse of what's happening in Washington, where banks are battling against potentially restrictive regulation of over-the-counter trade, some in China are hoping for clearer rules that will give them the certainty and confidence they need to sell more hedges, whether simple or complex structures.

There are signs of that happening: SASAC has ordered state firms to stop speculative trading, limiting derivatives trade to that related to their actual business, but still allowing them to take positions totaling up to 1.1 times their physical demand.

"More regular and stricter oversight will be carried out to make sure no speculation will happen again, and we will ask state firms to avoid complicated products," a SASAC official told Reuters, declining to be named due to the sensitivity of the issue.

But the definition of a "hedge" is often open to interpretation, particularly on deals that are more complex, and it remains unclear how Beijing will address that distinction in the often chaotic and opaque industry.

No concrete rules cover the over-the-counter (OTC) market and derivatives trading. Although only 31 state firms are authorized to trade derivatives abroad, many others manage to do so by taking advantage of obscure rules and the regulatory overlap between the state asset watchdog and the securities regulator.

While it's clear that SASAC will take the lead role in regulating state enterprises' derivatives activity, analysts say the securities and banking regulator might need to step in to oversee investment and commercial banks' dealings.

State firms will also likely be required to set up professional risk management departments and do more independent risk and pricing assessment before making purchase decisions, as Beijing forces them to take more responsibility for their actions.

DOMESTIC BANKS, FUTURES MARKETS

Industry sources also said Beijing is likely to encourage state firms to buy more risk-management products from domestic banks, although most have very little expertise.

China Development Bank CHDB.UL has a 5 year joint venture agreement with Barclays Capital (BARC.L), and Agricultural Bank of China has ambitions to become a global grains trader, but others have yet to establish themselves, traders say.

While China is the only country to take a semi-political stand on derivatives defaults, it is not alone in feeling the pain -- high-profile currency or commodity losses have also triggered disputes in South Korea, Hong Kong and India.

And investment banks have adapted as a result.

"Sell-side institutions are taking more responsibility for explaining potential outcomes covering best and worst case scenarios," says Ken Chan, regional sales manager of SuperDerivatives. "This is already being reflected by better client education and far more detailed term sheets."

And while Beijing -- like Washington -- may encourage its corporates to use more standardized cleared or exchange-traded products, officials acknowledge the need for sometimes bespoke hedging solutions to meet specific price exposure.

"What's sure is that exotic products such as accumulators with only limited upside but unlimited downside will be unwelcome," the SASAC official said.

Meanwhile, the finger-pointing goes on -- misleading hedges versus "caveat emptor" -- and banks fearful of future defaults are charging Chinese corporates a higher premium for the small amount of hedging business that still exists.

But some analysts said that may not hold true for long -- China has emerged from the financial crisis as one of the most coveted counterparties in the world, with a more solid economic foundation and better growth prospects.

"The hedging market is a buyer's market. Big and creditworthy clients are rare resources and guarantees for future profits," said the Singapore-based banker. "China, especially after the financial crisis, is a market with the lowest credit risks." (Editing by Jonathan Leff)


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