T-Bond Futures with Chinese Characteristics
After an 18-year hiatus, Chinese Government bond futures are back. After more than a year of mock trading the CGB finally went live on September 6, racking up an impressive first day’s volume of 36,635 contracts. The celebratory first day gave way to more humdrum reality the following week, however, as turnover dropped off toward 5000 a day, where it has been bouncing around since. Open interest, a more robust measure of the breadth of participation, has been climbed steadily from 2,959 after the first trading day and has also settled to around 4500 contracts as of early October.
Long-time observers of futures product launches know that nurturing a new contract is typically a marathon, not a sprint, as potential users study and learn how and why they should use the new instrument. China’s environment may pose additional challenges for a bond contract because government bonds are not investments well understood by retail investors—in good part, no doubt, because they can’t trade the cash product.
The new contract also suffers from the fact that Chinese banks have not been granted approval by their regulator, the China Banking Regulatory Commission, to trade them. Since banks own about 90% of the bonds outstanding, the biggest potential short hedgers are sidelined until the CBRC gives the green light.
Bond futures were the most actively traded financial contract in China in the early 1990s. Then in February 1995 came the “327 bond incident” a scandal involving leaked government statistics, a “shootout” between longs and shorts causing wild price gyrations just seconds before expiration, triggering the collapse of China’s then biggest brokerage firm and a jail term for its CEO. Bond futures got banned and regulators have been jittery about the product ever since.
But these days China is committed to a course of interest-rate liberalization. Regulatory reforms prompted by the abuses of the 1990s have long been in place. There’s also a growing appreciation for the basic function of futures. Authorities and market participants understand that the increased volatility that comes with liberalization, not to mention more uncertain economic times, bring the need for risk management tools.
The new CGB is not just knock-off of bond contracts traded elsewhere, such as the venerable CBOT (now CME) treasury futures, the U.K. Gilt, the German Bund, or Japan’s JGB. Its Chinese characteristics depart from these familiar templates in ways that may present both challenges and opportunities to traders and quants who make a practice of mastering the pricing implications of quirks in contract design.
The nearby table shows the contract specs. The par coupon is 3%. The notional value of the contract will be Y1,000,000, which is about $160,000 at a recent exchange rate of Y6.25 to the dollar. That’s a big contract by historical standards, and reflects Chinese regulators’ desire to discourage unqualified small speculators from jumping in. The U.S., U.K., and German fixed income contracts of comparable maturity each have a face value of 100,000 units, which puts the German Bund at about $133,000 equivalent (at the recent exchange rate of 1 euro = $1.33) and the 10-year Gilt at $153,000, close to the CGB. The Japanese JGB eclipses them all with a face value of 100 million (over $1Million).
The CGB will be quoted in the conventional way, as a percent of 100, with a tick size of 0.002, one-fifth of a basis point or Y20. That’s equivalent to $3.20, small compared to the 10-year T-Note ($15.625), the 10-year Gilt (10 BP or about $15.30), the Bund (euro 10 or $13.30), and JGB Y10,000 ($101 USD). Paradoxically, given that the contract size is intended to discourage retail players, the small tick size is intended to ensure participation of key liquidity providers—not institutions but the larger retail speculators.
Three contract months on the quarterly cycle will be listed at a time. Trading hours are from 9:15 AM CST to 3:15 PM, with 90 minute break for lunch starting at 11:30 AM. Trading ends at 11:30 AM on the last trading day, which is the second Friday of the contract month. An interesting feature is that the daily settlement price will be the volume-weighted average price (VWAP) in the last trading hour.
Though it’s called a 5-year contract, the deliverable basket includes any bonds with between four and seven years to maturity remaining as of the first day of the delivery month. In fact, that the CGB will be a de facto seven year contract. Why? When yields are above the par coupon, as is the case in China now, the cheapest-to-deliver contract will be the longest maturity contract in the deliverable basket. In China the CTD is likely to be the on-the-run seven year note.
No Wild Card
One difference between the CGB and some other bond futures is in delivery rules that eliminate—or at least drastically alter—the “embedded options” in treasury futures. Will that hurt or help the CGB? Experienced traders of treasury and other similar sovereign bond futures generally become fans of the embedded options that result from the delivery rules. “The embedded options in treasury futures create interesting opportunities for traders, arbitragers, and spreaders,” Mark Holder, an economist who worked at CBOT during its transition from an 8% to 6% coupon in the late 1990s is now a research economist at the Singapore Exchange”, said recently. “I think the embedded option has increased liquidity and contributed to the enduring success of the U.S. treasury complex”.
The embedded options all flow from choices provided to sellers--the shorts—to minimize the likelihood they can be subject to a “squeeze”. Bond traders refer to the quality option, or the ability to choose which of the deliverable bonds to deliver; the timing option, when to deliver; the end-of-month option, the possibility of profitable swings in yield after the last day of trading; and the wild-card option, from the six-hour window after the 2 PM close of trading and the 8 PM deadline for submitting a tender notice. As we shall see, of these, the CGB retains only the quality option, the short’s ability to choose what bond to deliver.
CGB deliveries are allowed starting on the first business day of the contract month, like most other bond futures. But in US treasury futures, shorts know for sure they can deliver any day they choose. When they submit a notice of intent to deliver, they’re matched with longs starting with the oldest long in the market (the one whose long position was established earliest). Not so with CGB deliveries. A short in the CGB can submit a notice of intent to deliver but will be matched only with longs who have tendered notices of willingness to take delivery. This eliminates the so-called “timing option” because shorts cannot know with certainty that they can deliver on a particular date. If it’s advantageous for shorts to deliver on a particular day, presumably the longs would be disadvantaged and decline to accept delivery.
The CGB contract expires on the second Friday of the delivery month. Any remaining longs and shorts must then go to delivery immediately. This again contrasts to the U.S. and some other similar bond futures in that these allow the short to decide when to deliver for the rest of the delivery month. Hence the end-of-month option will also be absent from the CGB.
The so-called wild-card option derives from the shorts having the flexibility to decide after the 2 PM close of trading up to the 8 PM deadline for tendering a delivery notice what bond issue to deliver. If there’s a big move in the cash market after the close, this option can create a sudden profit opportunity for the short, who can tender a bond or note different from the CTD underlying the price of the futures at the close of trading. With the CGB the longs would again presumably decline to take deliver.
The value of the embedded option is not insignificant. Depending on market conditions it can be a fraction of a point (a point is worth $31.25) per contract to several points or even more. The short “pays” for the embedded options in the form of a lower selling price when the position is established.
Don’t Squeeze Product
CFFEX gives longs the power to decide whether to accept delivery in part because institutional participants—mostly banks and securities firms—are more likely to be on the short side of the market, which means retail speculators will predominate the long side. Exchanges and FCMs don’t want retail speculators forced into delivery because they may not have the means to take delivery. FCMs in developed markets are generally vigilant about getting their retail customers out of the market before the delivery period, and in a worst case would help with the delivery process to avoid a default for which the FCM is ultimately liable. Chinese FCMs haven’t yet developed the same degree of solicitude for clients, say brokers there; hence, Chinese futures have more safeguards to prevent unwanted deliveries. Of course, all choice expires after the close of trading on the last trading day. The remaining open interest must go to delivery.
Curtailing the short’s delivery options may not hamper the contract. Some bond futures, such as Germany’s Bund, have just one delivery day immediately following the contract’s expiration and has worked well. It is the case though that market participants like to test the delivery mechanism because a smooth delivery is a crucial condition for “convergence” of the futures with the underlying cash market. Convergence is the holy grail of well-designed futures because without it the contract can’t be relied on to work as a hedge, which along with price discovery is a fundamental requirement of any futures.
A futures contract that can easily be manipulated is a bad one. One key to reducing the risk of manipulation is to design it so there’s plenty of supply of the deliverable grade. Shorts will easily get the product they need for delivery and will avoid getting squeezed. Like the U.S. treasury futures, the CGB does that by making the maturity band wide enough to encompass many different issues but not so wide that the contract breaks down as a hedging instrument. The U.S. 10-year note contract typically has a dozen or so deliverable issues and the long bond over 20. Based on existing Chinese bond issues and the current schedule of issues the CGB will have over 20 different deliverable issues for an aggregate theoretical value of about 1 trillion Yuan every expiration.
But there’s less there than meets the eye. Close to 90% of that supply is owned by the Chinese banks, and most of that the banks have to keep locked away to meet prudential liquidity requirements. Only around 15% of their holdings are in accounts they can use for trading. The 10% of Chinese sovereign bonds not held by banks is held by securities firms, insurance companies, and others. Of these the securities firms can and do trade their bonds and in fact account for well over half the trading volume in the cash market. The upshot is that the float, or value of bonds freely tradable, is only Y200 billion (equivalent to about $32 billion) for any delivery month, a fifth of the aggregate value of issues.
One advantage players in the Chinese bond market have over their peers in most other markets, however, is that they know the government’s issue schedule in advance. Every December the Ministry of Finance publishes the scheduled monthly issuance amounts by month. This matters especially under current yield conditions because the new issues, as noted, are likely to be the cheapest-to-deliver as long as yields are above the par coupon of 3%. Hence traders will know the size of the CTD for the relevant contract month in advance.
Who Can Trade
As noted banks are not allowed by the banking regulator, the CBRC, to trade futures. Until the rules are changed, the biggest players in the market will have to sit out the action. In any other market but China, that would be worrisome to the prospects for liquidity. In addition to securities firms as can individuals and non-financial companies can trade. Many unregistered funds trade futures (and stocks) in the Chinese market and they will be active as well. These funds are typically companies capitalized by a small number of investors who then hire a trader to trade on their behalf. In short, there should be enough liquidity to support a viable market till the banks can join in.
The foreign players in the Chinese securities and stock index futures markets are the Qualified Foreign Institutional Investors, or QFIIs, foreign investment companies such as mutual funds and endowments. As of the end of June there were 207 QFIIs with a combined investment quota of Y266 billion ($43 billion), about 1% of the free float. QFIIS didn’t get the green light to trade stock index futures until three years after launch and haven’t yet gotten the nod for bond futures. But given the current momentum by Chinese authorities to liberalize interest rates the wait will likely be shorter for bond futures than it was for equity futures.
Other foreign would-be traders will have to watch from afar unless they take steps necessary to create a Chinese joint venture with a license to trade futures. Unrestricted participation by global players won’t happen till China opens its capital account, that is, allows investment flows in and out without hindrance, a prospect that’s still years away.
Taking its Measure
How big will the contract be? How big will it get? China’s central government debt is much smaller than that of the U.S. in absolute terms—a little over a tenth the size. The community of hedgers, dealers, and market makers is small anyway since controlled interest rates have muted trading interest. Most of the outstanding debt is held to maturity, hence not available for trading. Interest rates still haven’t been fully liberalized, which distorts the yield curve and shields some market participants from the full brunt of interest-rate risk.
On the other hand, China doesn’t lack for enthusiastic, risk-loving traders. Its first financial futures contract, the CSI 300 (Nick-named the Hushen contract) was in the world’s top five by notional value within four months of its launch in April 2010, was #3 last year and has more than doubled in volume so far this year. Many Chinese commodity futures are in the top ranks in their categories. As interest-rate liberalization proceeds, volatility will likely pick up, spurring the need to hedge and attracting speculators. In short, as more players join the fray and gain experience, and interest rates become increasingly volatile it seems a good bet the CGB will eventually take its place alongside the other major bond contracts of the world.
About Nick Ronalds
Nick Ronalds is Managing Director at the Asia Securities Industry and Financial Markets Assocation