Chinese investors check out prices at a brokerage house in Nanjing city, east China's Jiangsu province. Photo: AFP
Chinese investors check out prices at a brokerage house in Nanjing city, east China's Jiangsu province. Photo: AFP

The China Securities Regulatory Commission (CSRC) is investigating the bond-related business of Sealand Securities, the brokerage at the heart of a scandal in the country’s debt market.

Sealand Securities defaulted on a bond transaction with Bank of Langfang in North China’s Hebei Province after a recent tumble in bond prices, local media reported last week.

Sealand Securities denied it later, saying it had no agreement with the bank and its company seal had been forged by two former employees. Bank of Langfang, in a statement on its website, also dismissed the media reports as rumor.

In an exchange filing on Tuesday, Sealand said that the Guangxi branch of the CSRC sent a special team to start on-site inspections on December 15. The brokerage said it will fully cooperate with the inspection.

The scandal has exposed the counter-party risk in the debt market, which has seen bond prices tumbling and yields spiking since late October, as China steps up efforts to reduce leverage in the banking system to prevent asset price bubbles.

The Sealand scandal could “trigger panic, and cause a breakdown of trust” between lenders and non-bank financial institutions, because the brokerage’s response is seen as a refusal to bear the losses, said Zhou Li, president at bond-focused asset manager Rationalstone Investment.

If the incident is not settled properly it could result in more selling, Zhou said. “I’m worried that the bond market has witnessed just the first wave of sell-offs.”

The scandal has thrown into the spotlight a loosely regulated type of bond agreement, a financing tool similar to a repurchase agreement. Such deals are typically backed by verbal promises rather than a formal agreement.

In a low-yield environment (China’s 10-year government bond yield fell from 3.5 percent in mid-2015 to a low of 2.6 percent in August and October this year) entrusted agreements have been widely used by securities firms to obtain leverage for bond transactions and thus meet guaranteed returns to investors.

But as China started to tighten liquidity after the economy showed signs of stability during the third quarter, bond prices began to fall, exposing the counterparty risks illustrated in the Sealand case, according to OCBC Bank.

“This incident has clearly dampened market sentiment and broken the trust between banks and smaller non-bank financial institutions. It may take some time to repair the trust. Therefore, we should still expect volatility ahead,” OCBC economist Tommy Xie wrote in a note on Monday.

But the crisis may not worsen further as Chinese authorities have enough ammunition to maintain relatively stable liquidity, Xie said.