Ban on informal 'drawer agreements' expected to reduce leverage ratio

China's financial regulators have tightened rules for bond trading, a move that may exert short-term selling pressure on the bond market but will help reduce excessive leverage and curb risks in the country's financial system, analysts said.

The People's Bank of China has issued a regulation in collaboration with the country's banking, securities and insurance regulators that banned financial institutions from engaging in the so-called drawer agreements, a kind of under-the-table deal that enables them to dodge regulatory requirements when it comes to using borrowed money to invest in bonds.

Analysts said the coordinated move by the regulators is the latest evidence of a tougher crackdown on irregular activities in the country's financial sector as the government has made curbing financial risks one of its key tasks.

The new regulation also aims at avoiding a repeat of the $2.4 billion bond scandal involving Chinese brokerage Sealand Securities in December 2016.

The drawer agreements are often conducted through informal or even oral agreements among banks, securities brokerages and fund managers. Such agreements allowed them to use bonds as underlying assets, with secretly negotiated loss guarantees to borrow money and to purchase more bonds.

It has led to the surge of leverage ratio in bond trading, which amplifies the overall risks in the country's financial system. It often exists outside the regulatory radar as such deals are not publicly disclosed or reported to regulators.

In the latest document published on the PBOC's website, financial institutions were ordered to report to the regulators if the outstanding volume of their bond repurchases and reverse repurchases exceeds certain limits.

The regulators also stressed that financial institutions must sign official written agreements for their bond repurchases and forward transactions.

"Some market participants have used irregular trading arrangements to avoid regulatory requirements and to amply trading leverage, which have increased the fragility and risks of the bond market," the PBOC said in a statement.

There will be a one-year period for financial institutions to improve their internal risk control mechanism in compliance with the new regulation, according to the statement.

Ming Ming, a fixed-income analyst with CITIC Securities, said the new regulation on bond trading is an extension of the country's effort to push financial deleveraging.

"It will allow the regulators to gain a more comprehensive knowledge about the risks in the system with more accurate financial data and information," Ming said.

Analysts at Shanghai Chongyang Investment Co, an asset manager, said in a research note that the bond market may bear short-term pressure as some financial institutions would seek to sell bonds in compliance with the new regulation. They added that mid- and long-end interest rates in the market will likely remain at a high level.

Pan Hongyu, a fixed-income analyst at Hua Chuang Securities, said the new bond trading rule is a signal that strengthened financial regulation will continue to be the main policy stance this year.

"There is no sign of any monetary loosening and the market liquidity will remain tight, meaning the bond market will continue to bear downward pressure," Pan added.