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China Caps OTC Derivatives in Setback to Hedge Funds, Brokerages

2023-11-15 12:55
Chinese regulators have told securities firms to stop expanding their over-the-counter derivatives operations involving individual stocks, limiting a
China Caps OTC Derivatives in Setback to Hedge Funds, Brokerages

Chinese regulators have told securities firms to stop expanding their over-the-counter derivatives operations involving individual stocks, limiting a profitable business for the brokerage industry and dealing another setback to hedge funds that deploy long-short strategies.

Regulators last week told multiple major brokerages to cap OTC businesses including total return swaps and options at the current levels, according to people with knowledge of the matter. Similar restrictions were imposed on lending of shares for short selling, as well as some proprietary trading activities, the people said, asking not to be identified as the so-called window guidance was private. Contracts only linked to stock indices or exchange-traded funds were exempted, they added.

The instructions came after the China Securities Regulatory Commission published revised risk-control measures for securities firms to better support the economy, easing capital rules for market making and asset management while raising requirements for riskier businesses like OTC derivatives. The benchmark CSI 300 Index is down almost 7% this year even after regulatory moves including tightening short-selling rules, slowing initial public offerings and cutting the stamp duty, as a prolonged property crisis weighs on the economic recovery.

In addition to the guidance on OTC derivatives, brokerages have notified some quantitative hedge funds that they can’t further expand the size of swap agreements that add leverage to the clients’ so-called market-neutral products, the people said. The caps limit an increasingly popular business known as “Direct Market Access” that has helped quants boost returns in a tough market environment this year.

The CSRC didn’t reply to a request seeking comment on the broad restrictions. Reuters earlier reported on the cap on DMA operations.

Almost 99% of the market-neutral stock products — those that balance bullish and bearish positions — by hedge funds managing more than 10 billion yuan ($1.4 billion) each made a profit in the first three quarters, averaging a 5.6% gain, according to Shenzhen PaiPaiWang Investment & Management Co. The DMA model allows them to typically borrow as much as 300% of their investment from brokerages, fueling returns.

While DMA was initially mainly used by private quants for their proprietary trades, more and more managers have been selling such products to clients to boost assets, Citic Futures Co. analysts wrote in a report in August.

“DMA products are like an innovative, star strategy” this year, although quotas for external investors remain scarce, said Jiao Runmeng, a senior product manager at Shanghai Suntime Information Technology Co., which tracks hedge funds.

Chinese brokerages have been boosting OTC derivatives services in recent years. Such business stood at 2 trillion yuan including swaps and options as of Dec. 31, less than one tenth of interbank interest rate and foreign exchange derivatives, suggesting the market remains underdeveloped, according to an August report by CSC Financial Co.

More than half of the swaps business, which climbed 2% this year through July to 914 billion yuan, was driven by private funds, according to a Guotai Junan Securities Co. report in September.