When, at the beginning of 2008, Antoine Castel took control of the fixed-income unit in Beijing of Calyon, the investment banking arm of Crédit Agricole, the world's biggest banks were making fat profits in China's nascent derivatives markets.

But just weeks into his new job at the French bank, Mr Castel watched in horror as Chinese companies began to lose billions of dollars on the bespoke trades they had struck with western dealers. It was the start of a chain reaction that this summer unleashed a fierce backlash from regulators and local banks.

In stark contrast to the slow pace of reform in derivatives markets in the US and Europe, China's regulators have in recent months shut down the main route by which foreign banks sold derivatives from offshore operations and have banished speculative deals – moves that have important implications not only for Chinese companies and foreign banks, but also for the evolution of China's capital markets and the internationalisation of the renminbi.

As a result of the sweeping regulatory overhaul, trading volumes have plunged and foreign banks are scrambling to adapt to doing business in the new environment. “If you compare the business we are doing today with the business we were doing two years ago, it's completely different,” says Mr Castel. “You have to forget about [the old] market. It's gone.”

Previously, dozens of western banks such as Goldman Sachs and Morgan Stanley were striking huge deals with mainland companies that wanted to manage their exposure to swings in commodity prices, interest rates and currencies.

In two cases where trades went spectacularly wrong, Citic Pacific, the Hong Kong-listed arm of China's largest investment conglomerate, lost $1.9bn last year on bets against the Australian dollar, while Air China, the country's flag carrier, lost $1.1bn on oil derivatives.

They were just two of hundreds of companies that entered trades that were wildly mismatched with their hedging requirements, market participants say.

Chinese regulators suspect that in some instances companies used derivatives as a way to speculate, rather than hedge, while banks frequently sold overly complex products – the most profitable – without fully explaining the potential downside.

Products with names such as “snowballs” and “snowblades” proliferated, many with so-called “zero cost” structures that failed to live up to their name. Dealers say billions of dollars of trades are being renegotiated in private, some under pressure from Sasac, the shareholder and regulator of hundreds of state companies.

Total trade volumes have more than halved since a year ago, say market participants. Complex trades have vanished from the market.

“We are selling plain vanilla business in China, that is it,” says Mr Castel.

Deals that banks were once able to complete in five minutes over the phone now take an hour as the risks are explained in detail, says Mark Wightman of Super Derivatives, a data provider. The biggest shock to the established order came this summer when the China Banking Regulatory Commission banned most of the trades that can be originated offshore.

Until recently, almost all derivatives deals between foreign banks and China's industrial and commercial companies were struck overseas, typically in Hong Kong. To surmount obstacles including foreign exchange controls that made it difficult to trade with Chinese companies directly, overseas groups would typically get mainland banks to stand in the middle of each deal for a fee. These “intermediary trades” also allowed those overseas groups to minimise their credit risks by dealing with a small number of big banks rather than dozens of more risky companies.