Understanding Swap Facilities

• News
• 2024-06-06

The People's Bank of China (PBOC) has introduced a swap facility for non-bank financial institutions, which, in principle, does not increase the base money. This facility can significantly enhance the capital acquisition and stock purchase capabilities of non-bank institutions, which is conducive to strengthening the inherent stability of the capital market.

On October 10th, the PBOC issued a public market operation announcement: To implement the requirements of the Third Plenary Session of the 20th Central Committee of the Communist Party regarding the "establishment of a long-term mechanism to enhance the inherent stability of the capital market," and to promote the healthy and stable development of the capital market, the PBOC decided to create the "Securities, Funds and Insurance companies Swap Facility (SFISF)" to support eligible securities, fund, and insurance companies to swap high-quality liquidity assets such as bonds, stock ETFs, and constituents of the CSI 300 index for government bonds and central bank bills from the PBOC. The initial operation scale is 500 billion yuan, and the scale can be further expanded as needed. From now on, applications from eligible securities, fund, and insurance companies will be accepted.

From the PBOC's announcement, it can be seen that the creation of the SFISF tool is aimed at "establishing a long-term mechanism to enhance the inherent stability of the capital market." Its main purpose is to enhance market stability and act as a support. So, how does the SFISF tool operate and enhance the inherent stability of the capital market?

In addition, the PBOC will also create a special re-lending facility for stock buybacks and increases, guiding banks to provide loans to listed companies and major shareholders to support stock buybacks and increases. On September 24th, PBOC Governor Pan Gongsheng stated at a press conference, "This tool guides commercial banks to provide loans to listed companies and major shareholders for the purpose of buying back and increasing shares of listed companies. The central bank will issue re-lending to commercial banks, providing 100% funding support, with a re-lending rate of 1.75%, and the loan rate that commercial banks issue to customers is around 2.25%. The initial quota is 300 billion yuan, and if this tool is used effectively, another 300 billion yuan can be added, and even a third 300 billion yuan can be considered."

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Although these tools to support the stability of the capital market have just been introduced and may not have been truly used yet, the "expectations" they have generated have already provided significant support to the capital market. Since a series of policies supporting the real economy and the capital market were introduced on September 24th, by October 16th, the Shanghai Composite Index had risen by approximately 16.5% from its low.

The Operating Mechanism of SFISF

The newly created tool by the PBOC targets eligible non-bank institutions, including securities, funds, and insurance companies. Pan Gongsheng pointed out at the press conference on September 24th that the SFISF tool "supports eligible securities, funds, and insurance companies to obtain liquidity from the central bank through asset collateralization, and this policy will significantly enhance the institutions' ability to acquire funds and increase stocks."

It is evident that the SFISF tool can be divided into two stages: The first stage is that eligible non-bank institutions can pledge their bonds, stock ETFs, CSI 300 constituents, and other assets to the central bank in exchange for more liquid assets, such as government bonds or central bank bills. The second stage is that non-bank institutions use the high-quality liquidity assets obtained through collateral and other means to finance in the secondary market, and then invest the financed funds into the stock market.

Why can this process significantly enhance the institutions' ability to acquire funds? Let's first look at how non-bank institutions acquire funds without using the SFISF tool: Non-bank institutions directly pledge their bonds, stocks, and other assets and pay a certain interest rate, and they can finance a certain amount of funds in the secondary market.

Given this, why is it necessary for the PBOC to create a SFISF tool? Because there is a significant difference in credit rating and liquidity between government bonds, central bank bills, and other assets held by non-bank institutions. Pledging assets of different credit ratings in the secondary market for financing will result in different amounts of money that can be financed and different financing interest rates. The higher the credit rating of the pledged assets, the more money that can be financed, and the lower the financing interest rate that needs to be paid.Non-bank financial institutions may hold a significant amount of bonds, stock ETFs, and constituents of the CSI 300 index, among other assets. By utilizing the SFISF tool (which may require a certain fee rate), these assets can be exchanged for high-credit-rated assets. Subsequently, non-bank institutions can more easily secure financing in the secondary market with these high-credit-rated assets and obtain a larger amount of funds.

The new tool created by the central bank bears some resemblance to the Term Securities Lending Facility (TSLF) established by the Federal Reserve in 2008. According to CITIC Securities, in March 2008, the Federal Reserve introduced the TSLF tool to address the global financial crisis. Its purpose was to alleviate the liquidity pressure faced by financial institutions by allowing them to borrow Treasury securities with a fixed term using various collateral (investment-grade corporate bonds, MBS, or ABS). At a time when the entire market was facing a liquidity crisis in 2008, this tool provided a fund flow of up to $200 billion, easing the short-term liquidity tension faced by institutions.

However, the SFISF tool and the Federal Reserve's TSLF tool have different purposes. Currently, non-bank institutions in China do not have liquidity issues, and the SFISF tool is primarily aimed at enhancing the stock-increasing capacity of non-bank institutions, thereby enhancing the inherent stability of the capital market.

Enhancing the Inherent Stability of the Capital Market

The central bank currently holds approximately 2 trillion yuan in government bonds, which can be considered the "ammunition" for the central bank's swap convenience tool. What market impact will this tool have?

Firstly, the swap convenience tool increases the potential leverage capacity of non-bank institutions. Huatai Securities believes that the pledge rate for stock ETFs is usually between 30% to 60%, while the pledge rate for government bonds is around 90%. Therefore, the swap convenience tool significantly enhances the ability of non-banks to leverage.

However, the central bank is not encouraging these non-bank institutions to blindly increase leverage. In reality, for insurance and securities proprietary trading, they do not lack high-grade collateral because insurance and securities proprietary trading generally allocate most of their funds to bonds (including government bonds). When they need to leverage, they only need to mortgage their high-grade assets for financing. Additionally, insurance institutions have strict proportion limits on their stock allocations.

Huatai Securities believes that the current problem faced by institutions like insurance is more about the lack of assets rather than the lack of funds. Therefore, the swap convenience tool is more of a strong support tool, which is conducive to the stability of the capital market.

Minsheng Securities also believes that the rapid rise in the stock market is not the policy target of this tool; avoiding insufficient market liquidity and maintaining the stable and healthy development of the stock market is its main purpose.

Secondly, if non-bank institutions only exchange high-grade assets from the central bank and then finance in the secondary market, there will be no injection of base money.CICC believes that without the injection of base money, swap facilities could potentially impact the prices of stocks and bonds through asset rebalancing effects. Central banks can guide financial institutions to actively engage in swaps by setting the terms of the swaps, such as offering lower swap rates or longer swap durations. If the swap rates are sufficiently low, the swap durations are long enough, and the dividend yield of stock assets is significantly higher than the swap rates, after weighing the price risks, financial institutions may conduct swap operations and invest in the stock market. The result of the swap facility is a reduction in the supply of risky assets in the market (as they are used as collateral for the central bank and cannot be sold), while the supply of safe assets (such as government bonds or central bank bills) increases. Assuming that the original ratio of safe assets to risky assets held by all financial institutions is at a desirable level, after the swap occurs, the weight of safe assets in financial institutions increases, and the weight of risky assets decreases, financial institutions will then have the incentive to rebalance their assets, leading to an increase in the value of risky assets.