Forgery case reveals need for regulatory overhaul

By Li Qiaoyi Source:Global Times Published: 2016/12/26 22:23:39

Illustration: Peter C. Espina/GT

Illustration: Peter C. Espina/GT

The recent bond market forgery, which could incur losses of hundreds of millions of yuan, has sounded the alarm not only on risks in relation to proxy holding arrangements that are prevalent in China's bond market, but on the issue that the country's broader financial oversight regime hasn't been improved in an all-round way.

While putting out the fire that spotlighted lax internal controls at brokerage firms seems to be the top priority, a renovation of the entire alarm system, that could prevent regulatory arbitrage, actually merits more attention.

In a filing to the Shenzhen bourse on Thursday, Sealand Securities, which has recently been at the epicenter of a bond forgery scandal, said forged bond pacts involved in the incident totaled no more than 16.5 billion yuan ($2.38 billion). The brokerage house, based in South China's Guangxi Zhuang Autonomous Region, stated it is operating as normal and that liquidity risks are controllable. The filing came on the heels of a Wednesday statement in which Sealand Securities said it would hold itself accountable for the forged bond agreements, after previously putting the blame on two employees who allegedly signed the pacts using a falsified company seal.

The announcements quell fears that Sealand Securities might deny the ownership of the bonds which are held by a handful of financial agencies that suffered a huge paper loss amid the recent bond market rout. Following the statement on Wednesday, China's 10-year treasury bond futures for March delivery rebounded briefly.

However, the makeshift solution - reached following the intervention of the Securities Association of China which reportedly held an urgent gathering on December 20 of Sealand Securities and about 20 other financial institutions involved in the forged pacts - barely addresses the fundamental problem behind the incident.

At the heart of the issue is bond proxy holding deals, tantamount to repurchase agreements, in which the borrower agrees to redeem bonds that are sold to and held by the lender for a specific period of time. The borrower has to pay the lender a fee, and is supposedly held responsible for losses if bond prices fall. The practice enables securities firms to dodge regulatory limits for risky asset holdings. More importantly, it lays the groundwork for leveraged bets to be placed on a bull run in the bond market, as the borrower could cash the bond at a discount and use the money to buy new bonds which could be cashed again, the repetition of which would result in a pileup of leverage.

In the recent bond bull run, commercial banks and other financial institutions indulged in the proxy holding spree to such an extent that they opted to turn a blind eye to the potential risks involved. Neither Sealand Securities nor its many counterparties can entirely pass the blame on to the two perpetrators who allegedly falsified the company seal. The occurrence of the forgery itself indicates weak internal controls and ineffective compliance regimes at each of the parties involved in the incident. Sealand Securities said in a statement on December 18 that its company seal on the forged bond pacts was different from the one on record with the public security system, which indicates that probably no one bothered to verity the seal when signing the bond proxy holding deals.

As such, there is much more that needs to be done than simply reaching an agreement about honoring the bond pacts. Compliance and internal audit departments, particularly within brokerage firms, need to truly play their part in filtering out risks.

On top of that, the country's financial oversight regime as a whole needs to be rebuilt to manage risks in a holistic fashion, as past efforts to patch up the regime in bits and pieces have failed to eradicate the problems they meant to fix.

As with the bond forgery incident, the central bank's deleveraging efforts which siphoned off liquidity in the market and triggered the bond market correction are decidedly a cause of the incident and also lay bare the risks of proxy holding arrangements.

However, this is hardly a new issue. Early this year, fraudulent borrowing utilized to fund bets on the once-booming stock market also occurred, with Agricultural Bank of China and China Citic Bank among the lenders mired in bill financing fraud.

The latest bond fraud is in essence not much different, and just sends another alert to the government that has split oversight in the financial sector into several domains. There have been media reports suggesting that the country is mulling the creation of a super regulatory body that would prevent regulatory arbitrage and systemic risks. It is now time to say that this should become a reality in the foreseeable future.

The author is a reporter with the Global Times.


Posted in: INSIDER'S EYE

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