TJ, thanks for being the first to bring this issue to our attention. It's a fascinating story. Here's an update I found that I have not seen posted. The fraud issue you mentioned seems to have more merit to me than the comment "not counter-signed by legal representatives of state-owned enterprises". As posted, I think Agency law and Authority law would exist to make the contract binding (at least under Western Law), but claiming fraud negates all contract/agency law. Fraud Law is a completely separate animal, and trumps contract law if it can be documented and established.
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TOXIC TRADES
There appear to be two issues at the heart of the crackdown: how much information bankers gave their customers about the possible negative financial risk from entering into such deals; and whether the companies involved were knowingly speculating on global prices more than managing their own price risks.
"The move is not meant to cover a comprehensive range of businesses and companies. It's mainly to deal with some problematic contracts that were signed before, especially those that might have insufficient information disclosure or two parties have disputes over certain details," a government official with knowledge of the issue told Reuters on Tuesday.
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ANALYSIS-Banks, not commods, at risk from China OTC defaults
09.01.09, 6:22 AM ET
China -
* Official plays down defaults, cites "problematic" deals
* Execs see rising barrier to entry, but not flat price risk
* Crack-down targets complex structures, speculative deals
By Jonathan Leff and Chen Aizhu
SINGAPORE/BEIJING, Sept 1 (Reuters) - China's latest warning shot across the bow of its nascent derivatives industry sent shivers through markets this week, but it's bank risk salesmen, not oil or grains traders, who should fear the fallout.
If Chinese state-owned companies do walk away from losing over-the-counter deals -- an outcome that many industry officials still believe is unlikely given the legal battles that would ensue -- investment banks holding the other side of those trades could face hundreds of millions of dollars in losses.
On Tuesday a government official moved to downplay the significance of letters that were reportedly sent to six unnamed investment banks last week warning that state-owned companies could be allowed to default on OTC derivative deals.
"The move is not meant to cover a comprehensive range of businesses and companies. It's mainly to deal with some problematic contracts that were signed before, especially those that might have insufficient information disclosure or two parties have disputes over certain details," a government official with knowledge of the issue told Reuters on Tuesday.
But even the forced unwinding of those positions would be unlikely to cause waves in the vast futures markets for copper or oil, traders and industry officials say. There has also been no suggestion that importers of physical commodities like soybeans could default on trades, as some grain traders feared.
"The long-term risk is obviously significant. China is the key to commodities and nobody can ignore it, but they're not letting international players in very easily," said a senior official with a global bank in Singapore, who like others declined to be named due to the sensitivity of the issue.
"I think it's unlikely to be material to the global flat price. My guess is we're talking deals in the range of $50 to $100 million, rather than several hundred to a billion dollars."
Risk industry executives agreed that the contracts were likely to be primarily based on oil prices or metals, with airlines, shipping companies, some power producers and metals smelters the most common corporates to seek price hedges.
However the scale of most contracts is negligible next to the size of the futures markets where banks typically manage their OTC risks. One banker estimated deals of a few million barrels each, equivalent to under one percent of a day's NYMEX trade, and that any necessary unwinding would likely occur over many days.
Most imports of soybeans -- of which China is the world's biggest buyer -- are hedged on a short-term basis using Dalian or Chicago Board of Trade futures contracts, which are covered by margin requirements and outside the scope of Beijing's crackdown, which is focused mainly on more complex structured products.
"The policy will not affect soy futures, where state-owned companies hedge the commodity at exchanges against risks," said Wang Lingling, an analyst with Guan Tong Futures Co. Ltd.
Last week's warning -- even if narrower in scope than first feared -- is the latest in an escalating series of measures to limit the trade in more complicated derivative deals between global investment banks and state corporates that have totted up billions of dollars in paper losses on hedges since last year.
"It's getting more and more clear that no state-owned enterprise will be allowed to trade unless it's an absolutely iron-cast hedge," said the banker. "It's not promising."
Caijing did not report the identity of the six banks, and a wide range of industry officials said this week they were not able to confirm any bank that had received the notice.
TOXIC TRADES
There appear to be two issues at the heart of the crackdown: how much information bankers gave their customers about the possible negative financial risk from entering into such deals; and whether the companies involved were knowingly speculating on global prices more than managing their own price risks.
Last year, before the financial meltdown put a freeze on anything but the most vanilla of deals, banks offered to sell increasingly complicated structures such as knock-in, knock-out, which can generate income when markets are calm but can quickly turn toxic when volatility spikes, as it did a year ago.
"The lessons for China is that we have a very low knowledge base for risk management," said Prof Hu Yuyue, director of Securities and Futures Institute, Beijing Industry and Commerce University.
"We should more alert when being sold those products. They look beautiful, but we can't see the traps."
China may be the main event for the world's raw material markets as its galloping growth force it to import more of almost every commodity, but it is still largely a sideshow in the world of over-the-counter derivatives used by resource producers, consumers or traders to hedge their price risks.
China accounts for less than a quarter of banks' total commodity risk management business in Asia, according to industry officials, well behind the top market Japan.
One reason is that the derivatives industry is still new and underdeveloped in China, whose corporates have rapidly become more exposed to market forces over the past decade. Another is that some key sectors -- such as refining -- are still heavily regulated, giving them little reason to hedge.
Beijing is not alone in taking umbrage over such deals, particularly after commodity markets suddenly crashed last year.
In Sri Lanka, public interest lawyers, politicians and businessmen sued to block oil hedging deals struck by the state-owned Ceylon Petroleum Co. with five banks, which turned sour as oil prices fell, leaving a $400 million bill.
But Beijing and its companies will pay a long-term cost -- the inability to adequately protect themselves from rising costs.
"It's quite a short-sighted move. In the long run it will harm China. It will be a loss of business for banks but then it's better to lose business than to lose money," said a separate investment risk marketer at a major financial institution.
For many officials the involvement of the State-owned Assets Supervision and Administration Commission (SASAC) -- the nominal shareholder for state-owned companies and reported author of the letter -- heightened a risk that was already present.
Last year, as oil prices collapsed, small generator Shenzhen Nanshan Power <000037.SZ><200037.SZ> said that oil derivative deals with Goldman Sachs were unauthorised, triggering fear of a precedent that would allow others to default.
Ultimately, however, with China growing rapidly more dependent on imported resources -- and therefore its companies more exposed to global price risk -- many officials said the latest comments were more likely a warning against overly complex trades, not a call for a nationwide default.
"Everybody's going to be keeping a close watch on it, people will be more cautious about doing any deal going forward," said one trader. "But I don't think this thing will really happen." (Additional reporting by Eadie Chen and Niu Shuping in Beijing; Editing by ) Copyright 2009 Reuters
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