China stock suspensions opens can of derivatives worms

By Michelle Price

HONG KONG (Reuters) - The suspension of hundreds of mainland China stocks during a market plunge from mid-June could lead to disputes between banks and their clients over the valuation of billions of dollars of equity derivatives.

Banks dealing in derivatives are concerned that valuation terms covering market disruptions in other Asian markets, such as trading halts when stocks move up or down by the exchange's daily range limits, might not apply to the wave of stock suspensions in China.

As China's stocks tumbled by 30 percent in less than a month, around 1,500 listed companies, more than half the market, suspended their own stocks in a bid to sit out the rout.

"It's not yet clear if the existing disruption event language for other Asian jurisdictions can be applied to China or how the existing disruption definitions for limit-up, limit-down would apply to suspended stocks," said Keith Noyes, regional director, Asia Pacific, at the International Swaps and Derivatives Association (ISDA), which represents the world's largest derivatives dealers.

Noyes and an in-house lawyer at a major Asian dealer said banks were reviewing the issue.

"There could be wrangling over issues such as whether the Shanghai composite index closing price, which would generally be the easiest to use to value contracts, is a good price or a disrupted price, given that so many stocks are now suspended," said Noyes.

Dealers have written at least $150 billion of outstanding over-the-counter (OTC) equity derivatives on mainland-listed shares, according to estimates by Shanghai-based investment consultancy Z-Ben Advisors.

When drawing-up such instruments, most dealers draw on ISDA standard definitions as a basis for valuing equity derivative positions when the underlying stock market is disrupted.

The language was drawn up in 2008 following disruptions in the South Korean and Taiwan markets, when China's markets were all but closed to outside investors, and applies to a number of Asian markets, including Taiwan, South Korea, Singapore, and Hong Kong, but not mainland China.

Noyes said the dealer community may need to reach an agreement on whether it could be extended to China to help more easily resolve disputes.

Z-Ben says equity derivatives based on mainland shares have boomed for the past 18 months, as demand for access to China stocks rose during a year-long bull run that lasted until the abrupt reversal in June.

"Right now, dealers are going through their books trying to work out what their positions are worth," said Adam Sussman, head of execution and quantitative services at international brokerage Liquidnet. "In the end, someone is going to have to call the value of those deals, and someone else will lose out."

(Editing by Will Waterman)