Everbright Securities became one of the first companies allowed to conduct over-the-counter (OTC) equity swaps in China this month – a sign of the rising role such firms are playing in the development of the country’s capital markets.

Everbright’s 15-strong global markets division, led by managing director James Yang in Shanghai, is executing OTC derivatives with several Chinese insurers, helping them to hedge their portfolio allocation risk.

It comes after the China Insurance Regulatory Commission announced last October that insurers could trade derivatives, including listed equities futures, for hedging risk or locking in future prices within a month of assets they plan to buy.

“Insurance companies can use equity swaps to hedge market risk related with shares issued by listed companies through private placement,” explains Yang. “As these privately placed shares tend to lock the holders up for over a year, insurance firms would seek to use OTC swaps to lock in a profit from their investments.” 

Yang, who has formerly worked in equity derivatives for Prudential Financial in the US and Société Générale in Hong Kong, is one of a legion of foreign-educated graduates who has returned to China hoping to make use of their financial structuring or investment skills to tap increasing cross-border opportunities.

They want to play a role in channelling offshore capital into China’s financial market as the government gradually loosens its capital controls.

“The new approval to conduct equity-swap business has opened the possibility for many different products, such as delta-one swap and OTC options,” gushes Yang.

He notes that products such as callable bull/bear contracts are also now possible, although he expects them to be limited to the OTC market and sophisticated institutions at first. (In Hong Kong, such products are listed and traded on exchange.)

Guangfa Securities is another such firm understood to have applied for an OTC permit. It, too, is a non-bank institution active in structured products.

Both are seen as beneficiaries of the more progressive approach adopted by the China Securities Regulatory Commission (CSRC) under chairman Guo Shuqing and assistant chairman Zhang Yuchun.

These firms are eager to develop derivatives pricing and structuring capabilities closer to those of an equity derivatives trading desk at a foreign investment bank.

While the CSRC is seen as progressive, its banking counterpart, CBRC, tends to view bank derivatives businesses with caution following some high-profile implosions at Western banks post-crisis. Leading commercial banks in China only trade vanilla OTC interest-rate and currency swaps with one another as well as with insurers.

The thinking is that this leaves room for more innovation among securities firms under the more reform-minded CSRC.

But for now, the scope of equities hedging instruments in China still remains limited. Listed futures are available on the CSI 300 index, but options aren’t, for example.

Approved brokerages can provide margin financing, allowing investors to borrow and short stocks, but industry players note that short-selling is an illiquid business in China.

While Gilbert Tse, executive vice-general manager of Fortune SG Fund Management, welcomes more equities hedging tools being made available OTC, he takes a prudent approach to using such swaps.

“Different from exchange-traded derivatives where there’s more transparency around how risks will be dealt with by the exchange/clearing house, in the OTC space we still need to understand better the pricing dynamics of that OTC instrument, such as how daily NAV is calculated, its liquidity and mechanisms that could mitigate counterparty risk,” he says.

Fortune SG Fund Management is the Sino-French joint venture between Baosteel Group and Lyxor AM that specialises in quantitative investment strategies.