State-owned companies that apparently lost billions of dollars in derivatives trading are threatening international investment banks.
Wu Ying and Zhang Yuzhe 17 September 2009
(Caijing Magazine) With the permission of the Chinese government’s State-owned Assets Supervision and Administration Commission (SASAC), a group of state-owned enterprises (SOEs) have sent legal warnings to six international investment banks over derivatives trade losses, Caijing has learned.
Sources at SASAC, intermediary agencies and investment banks confirmed that the legal documents sent to investment banks in mid-August described Chinese investigations into commodity derivatives contracts bought by SOEs.
SOEs said they reserved the right to withhold payments.
News of possible defaults August 28 jolted commodities markets around the world. On August 31, for example, copper prices for three-month delivery fell 3.6 percent from the previous day on the London Commodity Exchange.
SASAC released more details September 7 on its Web site, announcing that some central government SOEs had written trade counterparts about contracts for oil-related derivative products. The agency said an internal investigation was under way, and that the government reserved the right to devise remedies.
A source told Caijing that, according to incomplete data, 28 central government SOEs were involved in the financial derivatives business in September, and that most had chalked up losses.
On September 9, a Wall Street Journal op-ed piece entitled Beijing Plays Hedge Ball reflected what was widely regarded as the voice of non-Chinese investment bankers. The article emphasized the supreme importance of market rules and contracts, saying Chinese companies that do not comply with contracts or refuse to abide by commercial law would send a wrong signal to the international business community.
The op-ed article said China Eastern Airlines, Air China and COSCO had filed derivatives-related documents with Deutsche Bank, Goldman Sachs Group, J.P. Morgan Chase & Co., Citigroup, and Morgan Stanley involving a combined US$ 2 billion in contracts.
Huang Ming, a finance professor at Cornell University, said Chinese SOEs should pause to reflect on their own corporate governance and risk controls. Also, he said, they should comply with rules of the game, coordinated with fairness and ethical standards.
But an SASAC official told Caijing, “Several billion dollars is not a small amount. How long does it take the SOEs to earn that amount?” The source also said SASAC has a series of strategies to deal with the matter.
SASAC said proper corporate behavior in commercial activities gives the Chinese side the right to resort to legal measures. The agency also said it would pay close attention and support the process, and that relevant SOE trading counterparts should assist in the investigation.
Huang said questions about greedy investment bankers should be considered in reviewing derivatives trading and pricing, and disputes should be handled on a case-by-case basis.
And one investment banker warned that payment defaults are “not worth the cost of a nation’s good name.”
SASAC and the National Audit Bureau started checking derivatives trading outcomes among SOEs in last September and in this February asked SOEs to submit their internal investigation reports. After that, Caijing learned, enterprises started delaying or refusing to pay margins due under derivatives contracts. Warning documents sent to investment banks in August merely confirmed these steps.
Caijing learned from an informed source that SASAC has responsibility for overseeing derivatives trading, but that its supervision is limited to central government SOEs conducting trades in oil-related structured options.
Quite a few SOEs lack credit lines on the international market and need help from Chinese commercial banks before signing contracts with international investment banks. This complicates the structure of derivatives trading.
After getting the SOE warning letters, investment bankers generally fell silent. Officials at Goldman Sachs’ Singapore-based subsidiary J. Aron turned down queries from around the world by saying they were on “business trips.”
Moreover, Caijing learned that J. Aron’s chief representative Ge Dongmei left the company in the first half 2009.
A senior executive in charge of derivatives at another international investment bank stressed that, for now, it would be unrealistic for SOEs to expect banks to discount their losses.
“The point is, what can we say to the board of directors” if SOE demands are met? asked a China chief officer of an international investment bank. “We would rather hope SOEs can find some flaws from a legal perspective to avoid losses lawfully and properly. If they cannot find legal deficiencies, they’d better fulfill their responsibilities.”
One SOE that suffered a loss is Chinese shipping and logistics giant COSCO Group. The company lost a lot of money on oil derivatives deals.
COSCO did not publicly disclose the losses until September. It replied to a Caijing query by saying its Singapore subsidiary China Marine Bunker (PetroChina) Co. Ltd. had hedged on diesel fuel prices. The company is owned 50-50 by COSCO and the oil company PetroChina.
Details were not disclosed, but an informed source said COSCO’s booked losses were in the billions of yuan.
COSCO’s case suggests that disclosed book losses probably represent the tip of the iceberg. A source at a major SOE told Caijing most state-owned companies with import-export and foreign exchange businesses are more or less involved in derivatives trading.
Only a trickle of public information about derivatives losses can be found in a few announcements from public companies. In September and October 2008, for example, several billion yuan in booked losses each were publicly disclosed by China Railway Engineering Corp. Ltd., China Eastern Airlines Co. Ltd., Air China and COSCO.
Persistent deficiencies in corporate governance and risk control within SOEs, as well as all kinds of secret activities tied to interest transfers, complicates these matters.
A lack of pricing capacity is a particular flaw among SOEs. “We do not even know how much these contracts are really worth,” said one SOE source. “There is no public market price for reference.
“Investment bankers said their pricing model is a kind of business secret, so we do not have a reference to look to when we sign contracts.”
Deng Weibin, formerly a senior executive at J.P. Morgan’s energy commodity derivatives office, said few Chinese SOEs can make independent pricing judgments for complex derivatives contracts written by investment banks.
In addition, swift decisions are necessary to control potential losses, or perhaps book losses while preventing the red ink from spreading when a market turns. But internal decision-making mechanisms at SOEs are not sufficiently flexible for quick decisions.
Caijing learned through sources at SASAC and the China Securities Regulatory Commission (CSRC) that SASAC has mapped out general requirements for SOEs in overseas hedging activities. The idea was to simplify products and encourage trading on securities markets.
A CSRC source said, “Trading on securities markets increases hedging costs, but considering the transfers of interest in OTC (over-the-counter) trading, the prices should be fair.”
Yet while OTC trading is in high demand, an SOE executive said the securities market cannot be used to reach hedging goals.
A year ago, SASAC asked central government SOEs to examine and report their derivatives trading positions. National auditors checked more than 20 SOEs in January and issued a report at the end of February.
On March 24, SASAC announced supervision of financial derivatives trading among central SOEs would be strengthened. It also discouraged trading in high risk, complex structured products, and banned all kinds of speculative trading.
What’s in the Cards
But are SOEs properly qualified to conduct across-the-board derivatives trading? Any answer to that question would require some documentation, but there is no written reference material on the subject.
The Chinese government has long held a rigid position on SOE hedging activities. Overseas commodity trading was prohibited before May 2001 when CSRC allowed a few SOEs, after receiving State Council approval and a CSRC license, to conduct commodity hedging activities overseas. By November 2005, CSRC had licensed 31 SOEs.
What’s worthy of attention is that these 31 licenses only let SOEs trade commodities on overseas exchange markets; none authorized derivatives trading.
And contracts between foreign investment banks and SOEs on the matter of derivatives trading are flawed. Some transactions took place before contracts were signed. A knowledgeable source said if SOEs find evidence of unauthorized trading, they can seek legal protection. Any transaction settled before a contract is signed can be nullified the rest.
Yang Xusheng, a lawyer and partner at the firm King & Wood, said a standard agreement called an ISDA (International Swaps and Derivatives Association) agreement is required for any derivatives trade on an exchange market. In addition, the two parties must sign a schedule and confirmation.
A source close to the SASAC investigation said ISDA agreements were not signed for a large number of the Chinese transactions at the root of the dispute because SOEs could not agree on deal details with investment banks.
“Our judgment is that if there is a lawsuit” over SOE payment defaults “each side has a 50 percent chance of winning,” said a source at one SOE.
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Opening Salvo in a Brutal Derivatives Battle
State-owned companies that apparently lost billions of dollars in derivatives trading are threatening international investment banks.
Wu Ying and Zhang Yuzhe
17 September 2009
(Caijing Magazine) With the permission of the Chinese government’s State-owned Assets Supervision and Administration Commission (SASAC), a group of state-owned enterprises (SOEs) have sent legal warnings to six international investment banks over derivatives trade losses, Caijing has learned.
Sources at SASAC, intermediary agencies and investment banks confirmed that the legal documents sent to investment banks in mid-August described Chinese investigations into commodity derivatives contracts bought by SOEs.
SOEs said they reserved the right to withhold payments.
News of possible defaults August 28 jolted commodities markets around the world. On August 31, for example, copper prices for three-month delivery fell 3.6 percent from the previous day on the London Commodity Exchange.
SASAC released more details September 7 on its Web site, announcing that some central government SOEs had written trade counterparts about contracts for oil-related derivative products. The agency said an internal investigation was under way, and that the government reserved the right to devise remedies.
A source told Caijing that, according to incomplete data, 28 central government SOEs were involved in the financial derivatives business in September, and that most had chalked up losses.
On September 9, a Wall Street Journal op-ed piece entitled Beijing Plays Hedge Ball reflected what was widely regarded as the voice of non-Chinese investment bankers. The article emphasized the supreme importance of market rules and contracts, saying Chinese companies that do not comply with contracts or refuse to abide by commercial law would send a wrong signal to the international business community.
The op-ed article said China Eastern Airlines, Air China and COSCO had filed derivatives-related documents with Deutsche Bank, Goldman Sachs Group, J.P. Morgan Chase & Co., Citigroup, and Morgan Stanley involving a combined US$ 2 billion in contracts.
Huang Ming, a finance professor at Cornell University, said Chinese SOEs should pause to reflect on their own corporate governance and risk controls. Also, he said, they should comply with rules of the game, coordinated with fairness and ethical standards.
But an SASAC official told Caijing, “Several billion dollars is not a small amount. How long does it take the SOEs to earn that amount?” The source also said SASAC has a series of strategies to deal with the matter.
SASAC said proper corporate behavior in commercial activities gives the Chinese side the right to resort to legal measures. The agency also said it would pay close attention and support the process, and that relevant SOE trading counterparts should assist in the investigation.
Huang said questions about greedy investment bankers should be considered in reviewing derivatives trading and pricing, and disputes should be handled on a case-by-case basis.
And one investment banker warned that payment defaults are “not worth the cost of a nation’s good name.”
Halt Payments
SASAC and the National Audit Bureau started checking derivatives trading outcomes among SOEs in last September and in this February asked SOEs to submit their internal investigation reports. After that, Caijing learned, enterprises started delaying or refusing to pay margins due under derivatives contracts. Warning documents sent to investment banks in August merely confirmed these steps.
Caijing learned from an informed source that SASAC has responsibility for overseeing derivatives trading, but that its supervision is limited to central government SOEs conducting trades in oil-related structured options.
Quite a few SOEs lack credit lines on the international market and need help from Chinese commercial banks before signing contracts with international investment banks. This complicates the structure of derivatives trading.
After getting the SOE warning letters, investment bankers generally fell silent. Officials at Goldman Sachs’ Singapore-based subsidiary J. Aron turned down queries from around the world by saying they were on “business trips.”
Moreover, Caijing learned that J. Aron’s chief representative Ge Dongmei left the company in the first half 2009.
A senior executive in charge of derivatives at another international investment bank stressed that, for now, it would be unrealistic for SOEs to expect banks to discount their losses.
“The point is, what can we say to the board of directors” if SOE demands are met? asked a China chief officer of an international investment bank. “We would rather hope SOEs can find some flaws from a legal perspective to avoid losses lawfully and properly. If they cannot find legal deficiencies, they’d better fulfill their responsibilities.”
COSCO Case
One SOE that suffered a loss is Chinese shipping and logistics giant COSCO Group. The company lost a lot of money on oil derivatives deals.
COSCO did not publicly disclose the losses until September. It replied to a Caijing query by saying its Singapore subsidiary China Marine Bunker (PetroChina) Co. Ltd. had hedged on diesel fuel prices. The company is owned 50-50 by COSCO and the oil company PetroChina.
Details were not disclosed, but an informed source said COSCO’s booked losses were in the billions of yuan.
COSCO’s case suggests that disclosed book losses probably represent the tip of the iceberg. A source at a major SOE told Caijing most state-owned companies with import-export and foreign exchange businesses are more or less involved in derivatives trading.
Only a trickle of public information about derivatives losses can be found in a few announcements from public companies. In September and October 2008, for example, several billion yuan in booked losses each were publicly disclosed by China Railway Engineering Corp. Ltd., China Eastern Airlines Co. Ltd., Air China and COSCO.
Persistent deficiencies in corporate governance and risk control within SOEs, as well as all kinds of secret activities tied to interest transfers, complicates these matters.
A lack of pricing capacity is a particular flaw among SOEs. “We do not even know how much these contracts are really worth,” said one SOE source. “There is no public market price for reference.
“Investment bankers said their pricing model is a kind of business secret, so we do not have a reference to look to when we sign contracts.”
Deng Weibin, formerly a senior executive at J.P. Morgan’s energy commodity derivatives office, said few Chinese SOEs can make independent pricing judgments for complex derivatives contracts written by investment banks.
In addition, swift decisions are necessary to control potential losses, or perhaps book losses while preventing the red ink from spreading when a market turns. But internal decision-making mechanisms at SOEs are not sufficiently flexible for quick decisions.
Twisted Matrix
Caijing learned through sources at SASAC and the China Securities Regulatory Commission (CSRC) that SASAC has mapped out general requirements for SOEs in overseas hedging activities. The idea was to simplify products and encourage trading on securities markets.
A CSRC source said, “Trading on securities markets increases hedging costs, but considering the transfers of interest in OTC (over-the-counter) trading, the prices should be fair.”
Yet while OTC trading is in high demand, an SOE executive said the securities market cannot be used to reach hedging goals.
A year ago, SASAC asked central government SOEs to examine and report their derivatives trading positions. National auditors checked more than 20 SOEs in January and issued a report at the end of February.
On March 24, SASAC announced supervision of financial derivatives trading among central SOEs would be strengthened. It also discouraged trading in high risk, complex structured products, and banned all kinds of speculative trading.
What’s in the Cards
But are SOEs properly qualified to conduct across-the-board derivatives trading? Any answer to that question would require some documentation, but there is no written reference material on the subject.
The Chinese government has long held a rigid position on SOE hedging activities. Overseas commodity trading was prohibited before May 2001 when CSRC allowed a few SOEs, after receiving State Council approval and a CSRC license, to conduct commodity hedging activities overseas. By November 2005, CSRC had licensed 31 SOEs.
What’s worthy of attention is that these 31 licenses only let SOEs trade commodities on overseas exchange markets; none authorized derivatives trading.
And contracts between foreign investment banks and SOEs on the matter of derivatives trading are flawed. Some transactions took place before contracts were signed. A knowledgeable source said if SOEs find evidence of unauthorized trading, they can seek legal protection. Any transaction settled before a contract is signed can be nullified the rest.
Yang Xusheng, a lawyer and partner at the firm King & Wood, said a standard agreement called an ISDA (International Swaps and Derivatives Association) agreement is required for any derivatives trade on an exchange market. In addition, the two parties must sign a schedule and confirmation.
A source close to the SASAC investigation said ISDA agreements were not signed for a large number of the Chinese transactions at the root of the dispute because SOEs could not agree on deal details with investment banks.
“Our judgment is that if there is a lawsuit” over SOE payment defaults “each side has a 50 percent chance of winning,” said a source at one SOE.
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