It was a typical workday morning at Wanjia Asset Management Co. in Shanghai’s downtown financial district, but the firm’s star bond trader Zou Yu was not at his desk.
Zou, 31, had mysteriously failed to report for his job as head of Wanjia’s fixed-income department. And his whereabouts remained unknown until five days later when the firm, on April 16, announced that the police had taken Zou into custody for alleged unspecified financial crimes.
Zou thus joined a growing list of allegedly unsavory bond traders, securities brokers, bankers, and fund managers nabbed by authorities this year in their effort to stop illegal deal-making on the nation’s interbank bond market.
Among those arrested this month were prominent executives including Yang Hui, fixed-income managing director at China’s largest securities firm, CITIC Securities, and Zhang Shougang, deputy general manager of the fixed-income department at Jianghai Securities.
Authorities followed other trails to executives working for Sealand Securities, Bank of Beijing, China Merchants Fund, and E Fund Management Co. Most of these executives have been questioned by police and released.
The push to prosecute rogue bond dealers had come from the top, several sources told Caixin. They said vice premier Wang Qishan, head of the Communist Party’s Central Commission for Discipline Inspection, had personally ordered the China Securities Regulatory Commission (CSRC) and other agencies to thoroughly investigate bond fraud and punish every perpetrator.
In each case opened so far, authorities have focused on individual traders. Neither banks nor any other financial institutions have been cited for violating bond market regulations. Moreover, authorities have yet to clearly spell out the charges facing those taken into custody.
Police have been working closely with bond regulators for more than a year. Concerned regulators include not only the CSRC but also the central bank and the National Association of Financial Market Institutional Investors (NAFMII), a self-regulatory organization of the inter-bank market.
Shortly after a police special task force was dispatched to visit the central bank’s Shanghai branch, all local fund managers and brokers were ordered by CSRC to assist police by turning over all relevant information about the bond sector.
The central bank also weighed in with an announcement that it would launch a major investigation of the interbank bond market in May.
China’s interbank market trades government bonds, enterprise bonds issued by state-owned companies, as well as short-term financing bills and company medium-term notes issued by companies. The market does not handle corporate bonds issued by private companies. Dominant players are commercial banks that generally steer client deposits into bond investments.
Given that bond traders at banks enjoy easy access to funds, said Wang Xingfeng, director of securities trade monitoring at Everbright Bank, the market offers plenty of opportunities for corruption because “there are a lack of restraints, but temptations abound.”
Opaque Environment
The framework for the interbank market features three types of trader accounts—Class A, Class B, and Class C—each of which is registered with the China Government Securities Depository Trust & Clearing Co. Ltd.
Banks are assigned to Class A accounts, and non-bank financial institutions use Class B accounts. The third group, Class C, is used by non-financial companies and has the most traders. Wealthy individuals could gain access to Class C accounts by setting up a firm under their name.
Murky deals in the bond market sneak past regulators’ supervision more easily than on stock exchanges because bond trading is less transparent. Transactions are handled one-on-one and are subject to negotiations.
Big financial institutions, including banks, have taken advantage of the flexibility of bond transactions. Some use underground repurchase agreements to temporarily offload to another company bonds that they would rather not hold for the moment. It would appear on the surface as two separate deals.
This often happens when a financial institution needs to prepare a financial report, Liu said, because its profitability may be negatively affected by bonds trading below their purchase price.
Indeed, a May 2012 document obtained by Caixin from the central bank’s Shenzhen branch said six local financial institutions used the bond-transfer tactic often between November 1, 2011, and February 29, 2012, in schemes designed to misconstrue financial results or meet regulatory requirements, such as capital adequacy ratios.
However, most questionable deals that took place in the interbank market involved Class C accounts, a source familiar with the system said, “Because the other two groups are financial institutions and only Class C accounts are directly tied to individual person’s interest.”
A fund manager, for example, can secretly open a Class C account and sell bonds to the funds he manages. These transactions can go unnoticed by supervisors if the funds and transaction levels are relatively negligible.
A crooked trader might control more than one Class C account, said Liu Shenghua, an official at the Guangzhou bureau of the central government’s National Audit Office.
Many Class C account owners also make money from bond arbitrage, functioning as intermediaries between large financial institutions that underwrite bonds.
“In a market where a single deal is worth at least tens of millions of yuan, a one-point increase in yield means significant earnings,” said a bond trader.
The problem is, however, some Class C account owners do not get their bonds the right way. Instead, they would use their personal connections to bond underwriters, and, in doing so, cut off the normal sales channel that could have been available to other bond traders.
“Only those closely tied to the issuance process could get bonds,” said one trader. “We cannot get bonds at normal prices and have to buy from the companies run by those people.”
As a result, the bond trader said, honest players “pay the price and they earn the difference. Not even a penny comes out of their pockets.”
In some cases involving multibillion-yuan issues, said a bond trader at a bank’s investment division, “not even the bank could subscribe to the bonds. But a Class C account holder alone could subscribe to 3 billion yuan.”
Such maneuvering is especially likely among fixed-income investment directors with the right access to funds and connections, the bond trader said.
These and similar practices have been widespread at times and so common that, according to several bond traders who asked not to be named, they’re considered industry standards.
Blame the Regulators
Many bond traders point a finger at the interbank bond market’s regulatory system, claiming it leaves room for rent-seeking. Others blame loopholes that allow transactions between two or more related parties.
Bond traders, for example, do not have to disclose their family ties to people who work for the government’s market regulators. Such reports are mandatory for other types of financial service providers in China, such as fund managers.
Everbright’s Wang said bond traders operate in an environment marred by inconsistent regulations and incentive mechanisms, as well as high credit risks.
Leveling the playing field, say some market players, would require improving the trading system’s transparency. In addition, a fund manager at Harvest Fund suggested that regulators “make sure issues are determined by the market” in ways that increase competition and encourage the development of privately offered funds.”
Some rule-breakers have apparently taken advantage of a regulatory loophole first exposed in 2010 during an investigation of Zhang Rui, who was then an official working at the Ministry of Finance’s treasury department. He was detained by a party agency in December 2010 and later handed over to a court, where he was convicted last year and sentenced to life in prison.
Zhang Rui was caught tipping off traders with text messages about pre-auction government bond prices. He was eventually found guilty of illegal bond trading through Class C accounts as well.
A source said Zhang Rui set up an investment company with his wife to trade short-term bonds and medium-term notes, even though the couple had, in an attempt to hide their assets, “secretly divorced a long time before. But no one at the Ministry of Finance knew because they continued appearing at various events as a couple.”
Investigators said Zhang Rui illegally pocketed more than 40 million yuan, most of which came from his Class C account trades. They also said he accepted 6 million yuan in bribes from a company that printed government bonds.
Zhang Rui’s case prompted the central government to pay closer attention to Class C account traders. Thus, investigators in 2011 caught up with Li Kun, who was then serving as financial markets department managing director at Yunnan province’s Fudian Bank.
Officials found Li rigged the bank’s internal control system and illegally used its money to trade bonds through several Class C accounts he controlled. He made money by taking advantage of the time gaps between payments and bond deliveries.
Crimes like these are essentially “using the money of state-owned financial institutions to fund one’s private businesses,” said a NAFMII official. “A single transaction on the interbank bond market usually involves hundreds of millions of yuan, much more than what a normal person could raise.”
A source close to the Zhang Shougang case said he had at the time of his arrest 150 million yuan in Class C accounts, although officials have yet to determine the amount he obtained illegally.
Class C account owners also use banks to hold their bonds, Liu said. In a typical agreement, the account owner requests a financial institution such as a bank to finance its planned bond purchase and hold his or her bonds after the deal. The loss or gain from the investment goes into the Class C account, and the bank earns a high interest rate.
The Li scandal prompted regulators to enact in late 2011 measures aimed at controlling retail investors’ access to bond accounts. They also made it harder for account owners to take advantage of bank resources for personal gain.
That same year, the central bank closed another loophole by prohibiting payments through Class A accounts for bond transactions on behalf of Class C accounts.
“In the wake of the regulation, Class C account operation levels have been greatly reduced,” said an official at Industrial Bank.
To date, though, these and other regulatory changes have had a limited effect, as underscored by the recent arrests of Wanjia’s Zou and CITIC’s Yang. Both men took advantage of Class C accounts controlled personally or by their relatives. And both were financial stars whose clever trading practices had benefited their employers.
A CITIC document says Yang, 38, correctly predicted price fluctuations in the bond market between 2008 and 2011, helping the firm earn above-average returns. The document also credited him for creating an offshore investment platform for CITIC in 2009 that’s now a major component for Hong Kong’s yuan bond market.