* Daily trading volumes down 90 pct from April high
* Collapse occurred before recent cash crunch
* Crackdown on corrupt trading practices reveals fake trades
* Difficulty exiting investments may give foreigners pause
SHANGHAI, July 3 (Reuters) - Daily turnover in China's once high-flying bond market has collapsed since April amid a crackdown on corrupt trading that has revealed how sham trades have inflated reported liquidity in recent years.
Authorities have arrested at least four bond traders and fund managers since April as part of an investigation into profit-skimming.
The probe has been accompanied by new rules clamping down on practices commonly used to skim profits and increase leverage.
Investigations have focused on abuse of 'proxy holding' trades, whereby one investor buys bonds on behalf of another, often using funds borrowed from a third party.
The trades can be considered bogus when the buyer and seller effectively belong to the same portfolio. Sometimes both accounts are controlled by the same individual.
"This regulatory windstorm starved many proxy holding trades to death," said an asset manager at a major Chinese brokerage.
The collapse in trading volumes could scare off foreign investors who were granted more access to the market in March, while the fall in bond prices has also forced domestic firms to postpone plans to issue bonds to raise debt.
"It's mainly due to new rules implemented in the bond market," said a bond trader at a European bank in Shanghai, when asked why volumes had collapsed.
While proxy holding is not illegal, the practice is open to abuse.
In some cases, a trader may transfer bonds to another account that he controls, then pocket the profit when the bonds are resold at a higher price.
Another recent rule targeted the high-risk shadow banking sector. It forbade trading bonds between different accounts controlled by the same institution.
Some banks had done this in order to raise cash to make payouts on maturing short-term wealth management products, even when the longer-term assets underlying these products had not yet matured.
Some investment firms are also suspected of using sham trades to boost their standings in industry league tables for trading volumes.
A cash squeeze that propelled interbank lending rates to record highs last month exacerbated a collapse of bond trading volumes, but the steep fall in business was underway well before that squeeze began.
Daily trading volume in China's interbank bond market averaged 282 billion yuan in the first five months of 2013 and hit an all-time high of 433 billion yuan on April 17, data from China's biggest bond clearing-house shows.
But turnover plummeted to 36 billion yuan on June 13, the lowest since the clearing-house began providing data to Thomson Reuters in May 2011. Volumes have recovered only slightly, to 47 billion, by Tuesday.
Market participants said volumes would recover slowly but are unlikely to approach recent highs anytime soon.
The People's Bank of China (PBOC), which oversees the interbank bond market, said in March that foreign firms approved under the Qualified Foreign Institutional Investor (QFII) program could apply for access.
Previously, QFIIs were limited to investing in stocks and the small number of bonds also listed on China's exchanges.
But poor liquidity, which limits ability to exit an investment, could make foreign investors think twice about entering the market.
China's top leaders recently called for a detailed plan to eliminate capital controls and open up the economy more fully to foreign investment.
Analysts say a deep and liquid bond market is essential to an economy's ability to absorb increased cross-border flows. Otherwise the large waves of capital flowing in and out could cause interest rates to fluctuate wildly.
Corporate bond issuance volumes rose 51 percent year-on-year in the first five months of 2013, and top policymakers have long said they want bonds to comprise a larger portion of overall social financing.
But momentum appeared to stall in June. Since June 20, more than a dozen companies have postponed previously planned bond issuances due to market volatility.
Most said they would raise money during the second half of this year, or the first quarter of next year. (Reporting by Gabriel Wildau; Editing by Simon Cameron-Moore)