It has been a grueling week for the financial industry in China, with the biggest investigation into the country's bond market in recent years continuing to unfold.

The media has reported more details of the recent arrests of financial executives who allegedly misappropriated funds by using shady bond trading practices.

Opening of accounts by securities brokerages and insurance companies in the interbank bond market has been halted, the China Central Depository & Clearing Co, China's bond clearing house, announced Thursday morning, according to cnstock.com, the website of China Securities Journal, Thursday.

In a meeting with large lenders Wednesday in Beijing, the central bank, which oversees the interbank bond market, required banks to conduct in-house inspection of trading accounts and straighten out irregular trading.

Liu Shiyu, the central bank's deputy head, required banks to submit detailed inspection plans to the central bank before 5 pm Friday, and report results of the inspection by May 10, said a report by the China Business News Thursday.

Chinese regulators have sent investigators to inspect trading records at brokerages in Beijing, Shanghai and Jiangsu Province, the Shanghai Securities News reported last week.

The arrests are believed to be a part of a nationwide crackdown on irregular trading in China's bond market. The financial industry expects more arrests of bond managers at the country's banks and fund management and securities companies in the coming days.

You're under arrest

By Wednesday, the list of arrested bond managers included Zou Yu from Wanjia Asset Management, Yang Hui from CITIC Securities, Xu Dazhu from Qilu Bank, Xue Chen from Southwest Securities, Ma Xide from E Fund Management, and Zhang Shougang from Jianghai Securities, according to media reports.

The arrested bond executives were suspected of having misused a trading technique called "substitute holding" for personal benefits. In substitute trading, an investor transfers bonds temporarily to a buyer for a fee. Then the seller will repurchase the bond from the buyer at an agreed price after a certain period.

The practice, which is popular in the interbank bond market, allows traders to leverage the original investment. It is similar to bond repurchasing but is more flexible.

China's interbank bond market is the major player in China's booming bond market, which was worth 24 trillion yuan by the end of March, according to Chinabond, the country's bond clearing house.

Currently, three different types of accounts can be used for trading in China's interbank bond market. Class A accounts are for banks, class B accounts are for financial institutions such as brokerages and insurance firms, and Class C accounts are for individuals.

Previously, only holders of Class A and Class B accounts could trade bonds in the interbank bond market. To increase market mobility, the central bank in 2000 allowed individuals to invest in the interbank bond market. Now the majority of bond investment is from individual accounts.

Substitute holding is not illegal in itself, but a lack of supervision creates leeway for fund managers to embezzle funds during the reselling process.

To evade regulation, there is sometimes no signed agreement between the seller and the buyer.

"Through substitute holding, bond executives can disguise profits and losses, and manipulate financial statements by increasing trading volume," Winnie Deng, senior analyst at Shanghai-based investment consultant Z-Ben Advisors, told the Global Times Wednesday.

"In the bond market, where a single transaction often involves millions of yuan, the profit made from differences in the selling and buying price is huge," Century Weekly magazine quoted a bond trader as saying Monday.

Capital market researcher Zhou Junsheng said there are more comprehensive regulations for Class A and Class B accounts than for Class C accounts.

"There is almost no supervision of Class C accounts, which makes it possible for investors to take advantage of loopholes in the system," Zhou told the Global Times Wednesday.

"Just like how the US government combats tax evasion, an effective way for the Chinese regulators to stop trading irregularities is by asking bond managers to return their gains made from illicit trading," financial commentator Ye Tan told the Global Times.

Problem goes deep

As news of investigations into trading irregularities spread over the last week, many brokerages halted not just substitute trading but all bond trading as well, according to a report by China Business News Wednesday, citing unnamed sources.

When contacted by the Global Times, Li Mingliang, an analyst at Haitong Securities in Shanghai, refused to comment on whether they trade with substitute holdings, or whether they have started carrying out in-house investigations, as per the regulators' request.

It was only after news of the executives' arrests that the public has discovered the magnitude of illicit trading in the interbank bond market.

In particular, the arrest of Yang Hui raised eyebrows, as he was the second in command of the fixed income department at CITIC Securities, China's largest securities brokerage by assets, with total assets of 168 billion yuan ($27 billion) at the end of 2012.

Another arrested executive, Ma Xide, fixed income portfolio manager at E Fund Management, reportedly made an illicit profit of 49 million yuan from substitute holding.

Zhang Shougang, the most recent arrest, reportedly controlled 1.5 billion yuan of assets from trading from individual accounts.

Investigations into illicit bond trading actually started a year ago, following the arrest in 2010 of Zhang Rui, former deputy chief of the State Treasury Department at the Ministry of Finance.

Zhang made illicit gains of 30 million yuan through substitute holding through an investment company. He was sentenced to life imprisonment in December last year, according to media reports.

Zhang's case brought the attention of financial regulators to irregularities in the bond market and more cases were subsequently found. In 2011, six executives in the financial department of Fudian Bank based in Southwest China's Yunnan Province were arrested after setting up Class C accounts to siphon profits.

Regulation of the bond market has been inadequate in comparison to efforts made in combating insider trading and other unscrupulous practices in the stock market by the securities regulator over the past year.

More measures should be put in place by the regulators, said Deng of Z-Ben Advisors.

"For example, there should be a credit rating system for high yield bonds to ensure the level of risk is within the bond yield," she told the Global Times.