Background of the introduction of the Notice

 In recent years, as the Chinese bond market has been developing continuously, the investors want and need to participate in the bond investment more. However, affected by the profit motive, some market participants increase leverage in various forms, directly or in a disguised form, in floor or over the counter, for greater profits. On December 13, 2016, Sealand Securities had a risky bond incident in which its former employee Zhang Yang and et al. did bond entrustment transactions in the name of Sealand Securities, and the case involved pending contracts of about 20 billion yuan and over 20 financial agencies. The “fake stamp” incident of Sealand Securities also directly triggered an entrustment crisis and bond catastrophe at the end of 2016, causing serious unhealthy impacts on the bond market. After that, the bond market participants continued to do illegal “entrustment” transactions, avoid internal risk control mechanism and supervisory requirements like on capital occupation, exaggerate the trading leverage, and trigger trading disputes, which made the bond market more vulnerable and full of latent risks. The 5th National Financial Work Conference and the 19th CPC National Congress in 2017 and the Central Economic Working Conference at the end of the year all set a clear requirement—“to keep the bottom line of no systematic financial risks.” Against some irregular trading acts in the bond market, the People’s Bank of China, China Banking Regulatory Commission, China Securities Regulatory Commission and China Insurance Regulatory Commission jointly developed before issuing Notice to Regulate Bond Market Participants’ Bond Transactions (hereinafter referred to as “the Notice”) in order to urge all types of market participants—when participating in transactions in the bond market—to strengthen internal control and risk management, improve all bond-related internal control systems, regulate bond trading acts, and keep their leverages under control at a reasonable level.

II. Regulatory requirements and influence of the Notice

1. It clarifies the scope of the regulatory body.

The Notice provides that for the purpose of the Notice, bond market participants (hereinafter referred to as ‘participants’) include various financial institutions in compliance with the relevant provisions on access to the bond market, qualified domestic institutional investors of various non-corporate products, and asset managers and custodians of non-corporate products. For the purpose of the Notice, bond transactions include spot transactions, bond repurchase, bond forward, bond lending and other bond transactions in compliance with the provisions.

Interpretation: This document extends the scope of the applicable objects and the scope of business of market bond transactions. After referring to the new provisions of the Notice, we can see that in addition to the floor bond markets in the exchanges, inter-bank bond markets and over-the-counter markets with big volumes of transactions are also under supervision, that privately-raised corporate bonds and publicly-raised corporate bonds will all be included in uniform supervision and regulation. What’s more, besides commonly-seen spot transactions and bond repo, bond forward and bond lending and other bond transactions in compliance with the provisions will also be put under supervision.

2. It raises new requirements on market participants’ internal control system and risk management.

The Notice provides, (1). A participant shall, according to the nature, scale and complexity of the bond transactions that it concludes, establish an internal control system penetrating all links and covering all business, prudently set scale, credit granting, leverage ratio, price deviation and other indicators through information technology means, and keep records of the whole process of the bond transactions.

(2). A participant shall separate proprietary trading, asset management, investment consulting and other various front desk business, and set effective firewalls in assets, personnel, systems, rules and other respects, and shall neither carry out business by personnel affiliation, contracting of business or any other contracting methods, nor relax management or offer excessive incentives in other forms.

(3).A participant’s compliance management, risk control, clearing and settlement, financial accounting and other middle- and back-office business departments shall comprehensively understand the bond transactions of the front-office departments and strengthen the compliance review and risk control of bond transactions.

(4).The front, middle and back office business positions shall be separately set and held by special persons with corresponding practicing capacity, and shall not be held by any person in a concurrent or mixing manner.

(5).Where there are separate provisions of the financial supervision departments, these provisions shall be strictly applied.”

Interpretation: a. The bond market has big potential risks, one of the reasons for which is that the bond market participants’ internal control systems are not yet complete, and the setting of positions of some participants is chaotic and effective separation of positions and departments has not yet been achieved. That explains why there were the bond entrustment disturbance and bond market catastrophe in the bond market at the end of 2016. Therefore, it has been repeatedly ordered by the regulatory departments to improve the internal control systems and risk indicators. It is for this reason that the Notice raises some specific requirements. 

b. According to the requirement set in the Notice, bond market participants’ internal control systems need to penetrate all links and cover all businesses. In particular, the financing scale, credit granting, leverage ratio (total positive repurchase balance/net assets), price derivation (namely the derivation of the transaction price from fair price; for the inter-bank market, it shall be evaluated by Chinabond indices; for the stock exchange market, it shall be evaluated by China Securities Indices; for buy-back operation, it may be based or DR or otherwise, depending on which is more appropriate; the caliber under current supervision is 30bp, above which examination and approval is requested) shall be set prudently. These will be the main regulatory indices, and records of the whole process of the bond transactions need to be kept, that is, records of enquiry, transaction confirmation, transaction order placement, back office fund allocation and settlements need to be kept to meet the regulation demand;

c. It has been stressed by the regulatory department through repeated orders that participants shall separate proprietary trading, asset management, investment consulting and other various front desk business and set firewalls. The Notice makes an even more explicit requirement to ban contracting methods like carrying out business by personnel affiliation, or contracting of business;

d. According to the new requirements in the Notice, the participants’ middle and back office positions will have greater responsibilities, and will intensify compliance review and risk control and comprehensively understand the business situation of the front office departments. It requires the front, middle and back office business positions to be set separately, and the middle and back office positions to be held by special persons with corresponding practicing capacity. The phenomenon that front desk staff hold middle and back office in a concurrent manner will be prohibited.

3. It clarifies the behaviors that are prohibited in bond market transactions.

The Notice provides, “1. No participant shall conduct tunneling, insider trading, manipulation of the market, avoidance of internal control or regulation in any form of bond transaction, or facilitate others' avoidance of internal control and regulation. Asset managers and custodians of non-corporate products shall, according to the relevant provisions, perform trading, settlement and other compliance obligations, and assume corresponding responsibilities. 2. Participants shall strictly abide by relevant provisions on account management in the bond market, not lend their own bond accounts or borrow others’ bond accounts to conduct bond transaction.

Interpretation: 1. Against the background of a sluggish bond market, tunneling in bond market transactions becomes even more possible. The Notice specially points out the prohibited behaviors in transactions like tunneling, insider trading, manipulation of the market, avoidance of internal control or regulation in any form of bond transaction, or facilitating others’ avoidance of internal control and regulation like bridge transactions, which may generate liabilities for violating regulations.

2. The Notice will strengthen control of market participants’ account management, and non-corporate products will have to perform trading, settlement and other duties. Trading settlement with big derivations may be risky, and the departmental private fund products or bond asset management products on the market are not allowed to engage in transactions by lending accounts.

4. It regulates both the trading platforms and the signing of agreements.

The Notice provides, “1. Each participant shall strictly abide by regulations on the bond market, carry out bond transactions in a regular way on designated trading platforms, and shall not carry out offline bond transactions without reporting them to the financial regulatory departments in advance. Money brokerage companies shall carry out brokerage businesses in a regulated way according to relevant provisions.

2. Each participant shall sign trade contracts and relevant master agreements according to relevant regulations following the substance over form principle. In case of bond repo transactions, a master agreement on the repurchase shall be signed in each transaction; in case of bond forward transactions, a master agreement on trading in derivatives shall be signed in each transaction. It is strictly prohibited to avoid internal control and regulatory requirements by ‘drawer agreements’ in any form or through disguised trading or combined training.

Interpretation: 1. The Notice requires all participants to trade on the designated trading platforms of the regulatory departments, and offline transactions can be carried out only after they are reported for recordation in advance. Money brokerage companies are mentioned in the Notice, indicating that such kind of market participants may be supervised with priority.

2. Regarding the link of contract signing which is prone to problems in bond market transactions, the Notice specially provides the substance over form principle, indicating that agreements that are signed in violation of relevant regulations, including “drawer agreements” in any form, may very possibly be deemed as invalid in the future.

5. It introduces new measures to regulate bond repo transactions.

The Notice provides, “1. To conduct bond repo, a participant shall follow the requirement of the accounting rules to involve the transaction into institution balance sheets and the list of non-corporate products and count it in such item as ‘resale after repo’ or ‘buy-back after sale’.

2. Bond transactions where it is agreed upon that bonds shall be held temporarily by other parties, but must eventually be repurchased, or be held temporarily by other parties, must eventually be resold are outright repo transactions, except entrusted subscription or entrusted payment during bond issuance and distribution. In outright repos, the repurchase party shall treat the bonds that are held temporarily by the counterpart party as its own bonds in financial accounting, on the basis of which it counts corresponding risk control indicators like regulatory capital and risk reserve, and involve them in scale, leverage, concentration and other index control in a uniform way.

3. When conducting pledged repo in the bond market, participants shall handle the pledge registration formalities according to relevant laws and regulations. The term of pledged repo and outright repo by participants must not exceed 365 days. With consensus of both transaction parties, pledged repo may redeem the pledged bonds, and outright repo may realize delivery in cash and early redemption.”

Interpretation: 1. The Notice requires all buying and selling behavior in bond repurchase transactions to be involved in institution asset sheets and the list of non-corporate products in practice, and it even clarifies the accounting item, which prohibits the tables in past transactions;

2. The Notice clarifies the repurchase party’s buy-out of bond ownership for the first time. Participants can no longer avoid regulation, and risk indicators and regulatory capital all have to be counted in, having a big influence on market participants’ accounting and risk control molds. Market participants will have to change their systems. Bonds held by the counterpart of the repurchase party in outright repo transaction will have to be counted in risk control indicators, and the standards of dual control are adopted.

3. It is also clearly provided in the Notice that pledged repo may be concluded by bonds or settled in cash, providing a new way to resolve the issue of outright repo in case of bond defaults in the future.

6. It reiterates the requirement to follow the prudent practice principle and reasonably control the leverage ratio.

The Notice provides that each participant shall follow the prudent practice principle, strictly abide by risk supervision indicators and requirements like liquidity and leverage rate that are developed by the People’s Bank of China and each and every financial regulatory department, and reasonably control the bond transaction leverage ratios. In case of any of the following circumstances, the participant shall report it to the competent financial regulatory department in a timely way:

1. For a depository financial institution (excluding development banks and policy banks), the balance of its capital for repurchase of self-run bonds or the balance of its capital for reverse repo of self-run bonds exceeds 80% of its net assets at the end of the previous quarter;

2. For other financial institutions, including but not limited to trust companies, financial assets management companies, securities companies, fund companies and futures companies, the balance of their capital for repo of bonds or the balance of their capital for reverse repo of bonds exceeds 120% of their respective net assets at the end of the previous month;  

3. For insurance companies, the balance of their capital for repurchase of self-run bonds or the balance of their capital for reverse repo exceeds 20% of their respective net assets at the end of the previous quarter;

4. For non-corporate products that are public equity products in nature, including but not limited to bank financial products, public securities investment funds that are launched openly to the social public, the balance of their capital for repurchase of bonds or the balance of their capital for reverse repo exceeds 40% of their respective net assets in the previous day, of which the percentage shall be 100% if it concerns close-ended funds and hedge funds;

5. For non-corporate products that are private equity products in nature, including but not limited to financial products that are launched to private bank clients, clients with high net worth and qualified institutional clients, capital entrustment plans, customer assets management plans that are issued by securities, funds and futures companies and their subsidiaries, and insurance assets management products, the balance of their capital for repurchase of bonds or the balance of their capital for reverse repo exceeds 100% of their respective net assets in the previous day.

Interpretation: The Notice once again highlights the prudent practice principle, and especially clarifies the leverage ratios for different types of market participants to conduct bond transactions. Once a participant’s leverage ratio exceeds the limit and the participant fails to report it to the financial regulatory department, such participant may be faced with a penalty from the regulatory department.

7. It strengthens supervision of transactions and establishes a data information co-sharing mechanism.

The Notice provides, “1. Market intermediaries shall strengthen daily monitoring of the bond transactions in the bond market, establish data information co-sharing mechanism, and report, in a timely way, to the People’s Bank of China and the financial supervisory department of situations where the participants are found to exceed the bond transaction leverage ratio, and make information disclosures to the market as required by the People’s Bank of China and the financial regulatory department.

2. The People’s Bank of China implies macro prudent management of the bond market, and may carry out counter-cyclical dynamic adjustments of the participants’ leverage requirement when necessary, and coordinates the financial regulatory departments to carry out regulation and management of bond transactions. Each and every financial regulatory department shall strengthen the supervision and examination of the internal system construction, regulation of bond transactions, and prudent levels of the leverage ratios of the financial institutions and other bond market participants under its control, and shall impose penalties on relevant legal and irregular behaviors in accordance with the law. The People’s Bank of China shall strengthen information co-sharing, coordination and communication with each and every financial regulatory department.”

Interpretation: 1. It reiterates strengthening the monitoring of transactions and the data information co-sharing mechanism, requests the intermediaries to report to the regulatory departments circumstances where data exceed the limits for recordation purpose while making timely disclosure of them. In the future, the market and the regulatory departments will have access to more comprehensive data on market transactions;

2. The Notice clarifies the regulatory function of the People’s Bank of China in bond market transactions, while stressing that information co-sharing and communication coordination mechanism shall be established among the financial regulatory departments.

8. It stresses self-discipline management and the one-year market transitional period.

The Notice provides, “(1) China National Association of Financial Market Institutional Investors and other industry self-discipline organizations shall improve relevant self-discipline rules, strengthen market participants’ self-discipline management, and maintain the market order.

 (2) This Notice shall enter into force from the day it is printed and distributed. The participants shall strictly abide by the requirements herein to check and rectify their internal control systems. Should any participant fail to complete the rectification within one year, it is not allowed to carry out bond transactions. For bond transactions which have not yet been settled the day this Notice is printed and distributed and do not meet the requirements herein, fulfillment of relevant contracts may be continued, but not renewed, and it shall be reported to the financial regulatory department and involved in the norms. Any substandard indexes relating to the trading scale, the leverage, the concentration that are caused by the above involvement into the norms can be exempted within a year.”

Interpretation: 1. As the inter-bank bond market keeps growing, China National Association of Financial Market Institutional Investors and other industry self-discipline organizations are becoming increasingly important. The Notice requests to strengthen self-discipline management, which is also a need of the current bond market in its development and fills the loophole in government regulation. It is believed that China National Association of Financial Market Institutional Investors and other industry self-discipline organizations will introduce corresponding supervisory documents, too.

2. The Notice sets many new requirements on the bond market, but it takes time for the market to adapt to the new regulatory system, so the regulatory department gives market participants a one-year-long transitional period, during which each participant needs to adjust their respective businesses and systems as required in the Notice. After the one-year period expires, non-compliance market participants will face the risk of being temporarily suspended.