NO 230 – APRIL 2012
Reform and innovation in Chinese capital markets

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WFE Focus January 2012
Chinese Futures Markets: Coming off a Booming Decade
NICHOLAS RONALDS
CFA, President, RhoFinancial Consulting

To all the superlatives that have been lavished on China one more deserves to be added: The unprecedented ascendancy of the country’s futures markets, which went from being a wild but obscure corner of the derivatives world to join the ranks of the world’s most actively traded futures. Last year the three most active agricultural futures in the world by contract volume were Chinese—the ZCE cotton and sugar contracts and SHFE rubber futures, which traded over 139 million, 128 million, and 104 million, respectively. Out of the top 10 agricultural contracts by volume, 7 were Chinese. The stock index futures contract, launched only two years ago, is second in the world by notional value after CME’s e-mini S&P 500 contract. From 2000 to 2010 contract volume on China’s three futures markets grew at slightly more than 50% annually, from 27 million in 2000 to 1,566 million in 2010. Last year saw the first decline in over a decade as a weak stock market plus measures by the authorities to discourage excessive speculation caused a painful 32.7% contraction in volume. Still, even allowing for the smaller size of Chinese contracts, the performance of China’s futures markets over the past decade has been stunning. But the story has just begun.

The ascendance of China’s futures was not a smooth one. China inaugurated its first true futures exchange in 1993. Its success spawned numerous imitators and soon Chinese futures were booming. A glance at the table of historical volumes (Table 1) shows a marked decline after 1995, however. What happened? The early boom in futures was too much, too soon. By 1993 over 30 futures exchanges were trading at least 50 contracts (no one seems to know for sure what the actual number was) on almost every imaginable instrument. Often the same product, with or without variations, traded on multiple exchanges.

Abuses were rife in this chaotic environment with fraud and price manipulation common. After a particularly egregious scandal in the bond futures contract (the “327 event”) the China Securities Regulatory Commission (CSRC), which had just been created with jurisdiction over securities markets, was given authority to clean up and regulate futures markets as well. The CSRC closed down all but three exchanges by the end of the decade: the original Zhengzhou Commodity Exchange, the Shanghai Futures Exchange (SHFE), and the Dalian Commodity Exchange (DCE). Of the 1000 plus futures brokers that had sprung up in the first few years, 80% were shuttered. Proprietary trading on the part of brokers was prohibited. In several waves of reform the CSRC issued strict regulations for futures, exchanges, and intermediaries. By the end of the 90’s this reformed and rationalized industry had a regulatory infrastructure to support renewed, healthier growth in the 2000’s. The stage was set for a second, longer boom.

Today the three exchanges collectively boast an impressive diversity of products,including several unique to China.

At the start of the last decade the three exchanges were trading just two or three contracts each, seven in total: Copper, Aluminum, and Natural Rubber at the Shanghai Futures Exchange; two varieties of wheat at the Zhengzhou Commodity Exchange; Soybeans and soybean meal at the Dalian Commodity Exchange. After these contracts enjoyed rapid—and scandal free—growth over the first four years of the decade, the CSRC had the confidence to start approving new contracts. Today the three exchanges collectively boast an impressive diversity of products, including several unique to China: PTA (Terephthalic Acid), an input for making polyester, LLDPE (linear low-density polypropylene), used for plastic bags and other synthetics, and steel rebar (Tables 2-4). In aggregate the three exchanges today trade 26 contracts over three times the number at the start of the decade: 9 each at the SHFE and DCE, and eight at the ZCE.

As the tables show, the DCE and ZCE remained primarily agricultural, though the DCE diversified into energy (coke), LLDPE and PVC. The SHFE added Zinc, Lead, Steel Rebar, and Wire rod to complement its original copper and Aluminum contracts, but it too branched out by adding gold and fuel oil.

Last year's swings were exceptional large, but volatility in volume has typified Chinese futures all along, with swings up or down in the high double digits not uncommon.

Volume Volatility

The nearby tables show dizzying volume changes last year, with product declines ranging up to -98%, but a few sharp increases as well such as those for gold (up 112.6%), LLDPE (+52.4%), Cotton (+59.9%) PTA (+96.25), and hard white winter wheat (+335.7%). Last year’s swings were exceptional large, but volatility in volume has typified Chinese futures all along, with swings up or down in the high double digits not uncommon. The reason for the volume volatility is doubtless due in large part to the preponderance of speculative participation. Because speculators tend to migrate toward products in rising price trend, volumes in China are particularly susceptible to volume swings triggered by price swings.

So far, this year is true to form: DCE volume is off a 36.9% in the first quarter compared to the first quarter of 2011 and ZCE is down again by a whopping 53.9%. On the other hand, SHFE is up 7.5% after halving its volume last year, but the new financial futures exchange, CFFEX (about which more below), has had a rip-roaring first quarter, up 73.7%.

The Chinese futures industry as well as the authorities would like to see the share of hedge participants and other professional traders increase. That’s one reason all three exchanges annually conduct hundreds of seminars around the country to educate agricultural and industrial users of the underlying product on how to hedge. In addition, in the past few years interest in nurturing a managed futures industry has taken hold. The hope is that a more “professional” futures market will increase price efficiency and insulate the volumes somewhat from roller-coaster swings in volume.

The Chinese futures industry as well as the authorities would like to see the share of hedge participants and other professional traders increase.

Financial Futures

In the wild early days of China’s futures markets the scandal that triggered official intervention and clampdown more than any other was the “327 T-Bond scandal”, named after the deliverable bond in the bond futures contract that existed until it was shut down in early 1995. The incident involved insider information and flagrant price manipulation in the final minutes of trading. The authorities responded by banning all financial futures.

The incident-free growth of futures markets in the first half of the last decade induced a thaw in official attitudes. The CSRC gave its approval for the creation of financial futures in 2006, and the China Financial Futures Exchange, or CFFEX, was inaugurated in September that year. A month later mock trading began on the CSI 300 stock-index contract, a cap-weighted index of large companies. (“CSI” stands for “China Stock Index”, but the index is also called the “Hushen” a word combining the abbreviations for Shanghai and Shenzhen, the two cities that host China’s two stock exchanges.) The exchange and market participants expected the CSRC to greenlight live trading sometime 2007, but there was a snag. The stock market was on a tear—having more than doubled in less than two years by the end of 2006--and regulators feared that introducing stock-index futures might add froth to the market. Approval was withheld in 2007. Then, in 2008, as the financial crisis unfolded, the air came out of the market and approval was withheld because of fears that the contract might exacerbate the bear market. Mock trading, however, continued at CFFEX through 2008, 2009, and into 2010.

Finally, in 2010, with the Chinese economy on a steady growth path and the stock market stable, the green light came, and on April 16, 2010, the CSI 300 was launched.

CSI 300: Contract Specs

The CSI 300 index was created in early 2005 with the index value set at 1000 as of December 31, 2004. The Multiplier is 300 Yuan (RMB). The settlement price of the nearby contract was 3431.2 on the first day of trading, giving the contract a notional value of 1,029,360 RMB, about $ 150,902 at the exchange rate prevailing at that time. That makes the Hushen an awfully big contract relative to other actively traded contracts, especially in the context of China’s per capital GDP. (The most active U.S. index futures contract, the e-mini S&P 500, is valued at about $70,000 today; the dollar value of the Hushen today is around $116,000.) The large multiplier was a deliberate decision aimed at discouraging participation of small speculators. The tick size is 2.0, for a tick value of 60 RMB. Listed contracts are two serial months and the nearest two quarterly months. Expiration is on the third Friday of the contract month, with the final settlement price based on the value of the cash index at the close of trading on the last trading day.

with volume up almost 74% in the first quarter of this year, the Hushen seems bent on solidifying its status as one of the biggest stock index contracts in the world.

A Strong Start

Contract volume on the first day of trading for the Hushen was 54,457 for all contract months. The next day it was over twice that, and by summer it was regularly trading over 300,000 contracts and sometimes over 400,000. By notional value, such volumes put the CSI 300 contract neck-and-neck with the world’ three most actively traded stock index futures contracts—an impressive achievement indeed. Over the subsequent 18 months, however, as the Chinese stock market trended downward, volumes moderated to between 200,000 and 300,000 with occasional dips below that range. Last year CFFEX actually had lower daily average volume than in its first year, a fact hidden by an overall annual increase of 8.9% owing to its mid-April launch in its first year. But with volume up almost 74% in the first quarter of this year, the Hushen seems bent on solidifying its status as one of the biggest stock index contracts in the world.

Who Can Trade

From the perspective of investors and traders outside China, the country’s listed derivatives have one fatal flaw: access is prohibited. Only companies and individuals within China may trade them. However, one exception to the prohibition is in currently in progress, and another may be in the offing. The first exception is for Qualified Foreign Institutional Investors, or QFII’s. QFII’s are foreign institutions that have been granted a dollar quota by the central bank (the People’s Bank of China, or PBOC), to invest in Chinese A-share stocks. As of mid-March, 2012, the aggregate value of the quotas was $24.55 Billion allocated among 152 QFIIs, according to China Daily, but approval of new QFIIs has been accelerating in recent months.

In May of last year the CSRC issued guidelines according to which QFII institutions may trade CSI 300 futures for hedging only, and funds used for margin collateral would come out of their quota allocation. To date no QFII’s have been able to take the plunge into futures, however. They need to establish a new futures settlement account to manage margin collateral, and to date a required rule change on the part of the PBOC has not materialized. In addition, the PBOC affiliate responsible for regulating and clearing foreign exchange transactions, the State Administration for Foreign Exchange (SAFE), needs to modify the investment scope of QFII’s to encompass stock index futures. Once these steps have been taken, it’s still uncertain how enthusiastically QFII’s will grasp their new opportunity. To trade futures they will have to sell enough stock to cover their margin requirements, and some market participants may be loath to make that sacrifice.

Another exception to the prohibition on foreign futures accounts is now in discussion. Many in China recognize that opening up its markets is an essential and inevitable process for the development of China’s financial markets and broader economy. Toward that end regulators and market participants have been discussing the possibility of listing a crude oil contract accessible to foreign traders. The idea is that such a contract might be listed in both dollars and Yuan and serve as a regional crude oil benchmark for Asia. It’s possible that a decision would be made before the end of the year.

Another route to trading China’s futures is available--to become Chinese. That is, a foreign firm that enters into a joint venture or creates wholly owned foreign enterprise (WOFE) in China would then come under Chinese laws and be qualified to use futures. For example, a foreign agribusiness, energy company, or metal mining or processing firm could use futures as a tool in its overall business management. Could a JV or WOFE be formed solely to trade futures? There’s no law on the books prohibiting any Chinese business from using listed derivatives, but engaging in activities outside the business scope granted to a foreign firm—a judgment call in many cases--could be deemed a violation.

regulators and market participants have been discussing the possibility of listing a crude oil contract accessible to foreign traders.

What’s in Store

Impressive as China’s futures markets have been in volumes and product listings, the potential for continued growth is considerable in light of all that’s not yet trading: interest-rate futures of any kind and options. The ranking of the most active listed equity index products around the world is dominated by options, for example, hence the potential for options in China is enormous. Similarly, the most active asset class in the U.S. and Europe has historically been interest rates. Rate trade in Asia has been relatively modest, however, no doubt at least in part because the low level of public debt in most Asian countries has kept sovereign debt issuance, and hence trading in them, relatively low. (Japan is a conspicuous exception.)

It appears likely these deficits will be remedied in the near future. Guo Shuqing, the Chairman of the China Securities Regulatory Commission, said in a January speech that the time was ripe for bond futures this year. Sure enough, the CFFEX initiated mock trading in bond futures the following month. The Assistant Chairman of the CSRC responsible for futures, Jiang Yang, said at about the same time that China should list a crude oil futures contract to serve as an Asian benchmark and be accessible to foreign traders. Options are also being discussed and it’s widely expected that the first options contracts may be launched if not by the end of this year, then next.

Bond futures and options in general won’t be without challenges. Historical precedent suggests that to be successful, a futures contract requires a reasonably well developed underlying cash market, and an under-developed cash market tends to stymie a new futures launch. To be sure, history also suggests that when a new futures contract does take hold it will in turn add depth and liquidity to the cash market. That is one of the key reasons plans for bond futures is finding support both within industry and among regulatory authorities. China’s bond market has been growing, and with central government bonds of 6.5 trillion yuan ($1.03 trillion) outstanding, the Chinese sovereign debt market ranks second in Asia and fifth in the world. But trading in cash bonds is relatively thin, and according to an article in Caixin, a Chinese financial magazine, mock trading in the bond futures has been “not lively.” The lack of an active repo market may also be a factor. Still, China’s record to date, and the enthusiasm of Chinese investors and traders, suggest prospects for the eventual success of bond futures are good. The proposed bond futures contract is for a CNY 1 million par value, 3% coupon bond with between three and seven years remaining to maturity. Final settlement will be via physical delivery.

The prospects for options look favorable but are subject to caveat. The Chinese regulatory approach is cautious and deliberate. If markets in coming months are well-behaved—free of markets disruptions from either within or outside China, of significantly increased volatility, and the like, a green light from the CSRC is likely. A spike in volatility or general market instability would likely put plans for options on hold.

China's bond market has been growing, and with central government bonds of $1.03 trillion outstan ding, the Chinese sovereign debt market ranks second in Asia and fifth in the world.

Come a Long Way

Despite all the impressive achievements, China’s listed derivatives markets are in their early stages. Options have yet to be listed, and if experience is a guide, options will dramatically increase the size of the listed derivatives market. Interest rate futures will add a new asset class and most likely enhance the liquidity of the cash market into the bargain.

Back in 2009 China’s state council, the chief administrative authority of the PRC, officially sanctioned the goal of Shanghai becoming a global financial center by 2020. For that to happen, China will need to continue to diversify its capital and risk-shifting markets such as futures. The authorities and industry are well aware that much remains to be accomplished if this goal is to be met.

For China’s futures markets, amazing as their performance has been, the path is not necessarily as easy as past successes might lead one to conclude. For one thing, as China opens up, its markets will have to compete for liquidity with well-established markets elsewhere in Asia as well as the U.S. and Europe. If hedgers and traders have their choice of markets, will China’s necessarily be a global magnet? The history of futures markets shows that liquidity begets liquidity. Rarely if ever do two markets in the same time zone successfully trade contracts for the same underlying instrument. On the other hand, similar products that differ due to quality or location may get a volume boost from arbitrage and spreading. To the extent China’s futures contracts feature unique characteristics, they should be able to retain and even grow their market share.

In short, China will face challenges in managing the growth and diversification of its listed derivatives. But who would bet against them?

About Nicholas Ronalds

Nick Ronalds is the founder and President of RhoFinancial, LLC, which specializes in financial and derivatives markets consulting and strategic advisory services with a focus on exchange-traded derivatives (ETD) in Asia. Ronald’s knowledge of ETD products, strategies, and exchanges encompasses: product development, clearing and settlement, risk management, and the risk characteristics of financial and commodity assets. Recent projects include: the development of the Futures Industry Association’s Asian affiliate—FIA Asia; strategic due diligence for a premier futures exchange and one of the world’s largest hedge funds interested in Asian start-ups; and numerous assignments with securities firms, a major global derivatives exchange, and many investment banks regarding their specific informational and strategic questions about Chinese and Asian commodity and futures markets.

Prior to starting his own firm, Ronalds was the Senior Vice President and Director of Global Markets for ABN AMRO Bank, where, as a key member of the core team, he created the first futures brokerage joint venture in China with China Galaxy Securities, China’s largest securities firm. Ronalds started his career as an analyst with the Chicago Mercantile Exchange (CME) and continued his advancement there to Managing Director of the CME/CBOT Tokyo office. As the only employee of both the CME and the Chicago Board of Trade (CBOT) ever, Ronalds headed business development for their joint Asia/Pacific office.

Ronalds has a Master’s Degree in Economics and International Diplomacy from Tufts University’s Fletcher School of Law and Diplomacy. He is also a GARP Certified Financial Risk Manager, a CFA Charterholder, and a past-Chairman of the CFA Society of Chicago. Ronalds’ numerous articles have appeared in The Wall Street Journal, Futures Industry, Caijing magazine, Nihon Shoken Shimbun (Japan Securities Daily), International Financing Review, Journal of International Financial Markets, and many more. Ronalds can be contacted at ronalds@rhofinancial.com.

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