China to upgrade bond hedging tool rules, paves way for launching CDS

A Chinese financial committee has proposed updating the rules for hedging debt defaults, a step forward for the country to launch credit-default swaps (CDS) and similar derivatives for the first time, sources said on Thursday.
The financial derivative committee under the state-controlled National Association of Financial Market Institutional Investors (NAFMII) met recently to amend rules governing the rarely used credit risk mitigation (CRM) market, the only bond default hedging tool in China for now, the sources with direct knowledge of the matter told Reuters.
NAFMII manages a major part of China's corporate bond issues.
The proposed new rules have included the guidelines for trading CDS and credit-linked notes (CLN), signalling official intentions to introduce the products in China for the first time, the sources said. The new rules will then be submitted for approval to the executive conference of NAFMII, which is entrusted by the Chinese central bank to supervise issuance of corporate notes, the sources said.
When contacted by Reuters, NAFMII had no immediate comments.
For years, China's now $7.5 trillion bond market has worked on the assumption that the government would not allow a default. Issuers were effectively guaranteed by the state.
Since 2014 though, China has cautiously allowed some bond issuers to default, although doubts remain as to how far the government is willing to go given that many issuers are state-linked and the risk to stability if the bond market crashes - which analysts say would have a much bigger impact than China's stock market slump last year. A CDS, typically used in developed markets, is a financial swap agreement under which the seller of the CDS will compensate the buyer in the event of a default or other credit event.
The proposed NAFMII rules will permit investors of the product to include in their agreements compensation for different degrees of credit risk, such as debt restructuring or the potential of an acceleration of debt maturity for unexpected factors, the sources said.
A CLN is a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors, while the issuer is not obligated to repay the debt if a specified event occurs.
The new rules will allow CDS and CLN to co-exist with China's existing CRM market, which was rarely used since it was set up in 2010 given a lack of defaults.