Central banks and regulators in China and Hong Kong will work on launching Swap Connect, a mutual access mechanism that will allow foreign investors to hedge the market risks of the 3.7 trillion yuan (US$553 billion) in onshore yuan bonds held by them.

As the latest mutual access mechanism designed to augment Hong Kong's role as an international financial hub, and to further open up mainland China's interbank derivative market, Swap Connect will first debut with interest rate swaps. These are over-the-counter, bilateral contracts that allow holders of a bond to manage their risks by swapping one stream of future interest payments for another, based on a specified principal amount.

At the initial stage, only Hong Kong and overseas investors will be allowed to access the mainland interbank derivative market through the so-called northbound trade, the city's Securities and Futures Commission (SFC), the Hong Kong Monetary Authority (HKMA), the People's Bank of China (PBOC), China Foreign Exchange Trade System (CFETS) and Shanghai Clearing House said in a joint statement on Monday. They are targeting the end of 2022 for the launch of this scheme.

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The latest development follows a cut in yuan bond holdings by foreign investors this year, as China's yield advantage over US Treasuries disappeared for the first time since 2010. This has affected even Chinese government bonds, which investors consider risk-free. Foreign investors have been pulling out of yuan bonds since March, bankers said. The yuan has depreciated by about 5.3 per cent against the US dollar year to date.

The Swap Connect scheme is being viewed as a "positive step" that will help foreign investors hedge their yuan bond bets.

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The mechanism will help foreign investors, whose holdings amount to just 2.7 per cent of the world's second-largest bond market, to reduce their risks in times of market volatility, Julia Leung Fung-yee, the SFC's deputy CEO, said during a Bond Connect anniversary summit hosted online separately by Bond Connect Company, which operates the scheme, on Monday.

"It will help investors reduce the risk from a big sell-off, which is common in times of market volatility," Leung said. "Over the longer term, this mechanism will help stabilise the [bond] market development in China, as it helps encourage longer term investing."

Swap Connect was positive news, as investor demand for yuan assets remained robust, Lu Weiming, president of Orient Securities, told a panel at the summit.

"Despite the impact of the Covid-19 pandemic, China has kept its policy focused on national development. The yuan exchange rates have remained stable compared to other emerging markets' currencies. Yuan [assets] can better meet the needs of investors for asset management," he said.

The Swap Connect, which may explore the inclusion of other derivatives later on, will be accessible through a connection between the clearing houses in both China and Hong Kong. The timetable for the southbound leg, which will enable mainland investors to access the Hong Kong financial derivatives market, was not immediately clear.

The new connect scheme is the latest mutual access mechanism to be launched since the southbound leg of the Bond Connect scheme, which was launched in September last year.

The Bond Connect, which was launched in July 2017, also debuted only with a northbound leg initially. It has today become a major bridge channelling offshore investors' transactions into China's interbank bond market, and will help boost foreign investors' participation further, Eddie Yue Wai-man, the HKMA's CEO, told the summit.

"Swap Connect will give northbound Bond Connect investors more hedging tools. It is conducive to bolstering international investors' participation [in China's onshore bond market]," he said.

In the five years since the establishment of the northbound connect, offshore investors have increased their holdings of yuan onshore bonds by 40 per cent a year to 3.7 trillion yuan, Pan Gongsheng, the PBOC's deputy governor, said at the summit.

To protect investors on both sides, regulators in Hong Kong and China will "take all necessary measures to establish effective mechanisms under Swap Connect to handle any misconduct in a timely manner", the regulators said in their joint statement.

The new connect mechanism creates an opportunity for onshore market makers to elevate their service, which will ultimately advance China's financial markets, said Bing Li, Head of Asia-Pacific for Bloomberg. Li was formerly the head of fixed-income at Bank of China (Hong Kong) before joining Bloomberg.

"This initiative opens significant new possibilities for a variety of derivatives that will unleash more foreign participation in China's bond market. Global investors are encouraged by China's ongoing commitment to open up its financial markets," Li said.

China's total outstanding onshore bonds stood at 91 trillion yuan, data from China Central Depository & Clearing shows.

Elsewhere, CFETS on Monday launched new services for foreign investors to enhance their participation in China's bond market. It now allows foreign investors to invest in China's interbank bond market through online channels, and institutions in mainland China and overseas to sign agreements electronically. In the collaboration with Bond Connect Company, it has also lowered service fees by 25 per cent for related trades starting July 11, and extended the foreign exchange market trading hours.

This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2022 South China Morning Post Publishers Ltd. All rights reserved.

Copyright (c) 2022. South China Morning Post Publishers Ltd. All rights reserved.

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