There is an inherent contradiction in China’s position among the world’s biggest producers and consumers of many metals — while prices are still set in the traditional trading centres of the London Metal Exchange and New York Mercantile Exchange.
Why isn’t China the price discovery home for these commodities?
The short answer is regulation.
There is often an enormous amount of red tape to be dealt with in the country. Listing a new contract, for example, in theory requires a simple approval by the Chinese Securities Regulatory Commission. But, in practice, the process is more convoluted. The CSRC will not approve a product unless a consensus has been formed by the State Council and almost any ministry or commission that might have some interest in the product.
Dalian Commodity Exchange
But the long answer is more subtle. Regulatory change in China is working to a different pace — and a much more deliberate tread — than the hectic rate Western markets demand as normal.
Foreign participation in China’s financial markets is restricted. There is a limited entry gate, through the Qualified Foreign Institutional Investor programme. This was launched in 2002 to allow licensed foreign investors to buy and sell renminbi-denominated ‘A’ shares listed on China’s mainland stock exchanges.
On May 26, for the first time, the Chinese authorities permitted QFIIs to trade in Chinese derivatives. The decision, which had been widely predicted, came sooner than expected, after a US-Chinese Strategic and Economic Dialogue meeting in Beijing.
But, as market participants had forecast, QFIIs are only allowed to use the new CSI 300 Index Futures at the China Financial Futures Exchange — not commodity derivatives. And no start date has been announced for the new policy.
Another, more complex method of entry for foreign companies is to acquire a Chinese trading firm. However, the foreign stake may not exceed 49%.
In commodities, non-Chinese firms — even QFIIs — are still barred from the three commodity futures markets of Dalian, Shanghai and Zhengzhou.
As a result, Emmanuel Faure, head of business development and sales for futures at HSBC in Hong Kong, describes the Chinese futures market as “purely a domestic market — albeit a very successful one”.
This is the main reason why the benchmark prices for goods such as copper, aluminium and oil are still set in London and New York.
Benchmarks will move
But the present state of affairs is unlikely to last forever. Futures specialists say that if the Chinese government and the CSRC do decide to allow international participation, commodity price benchmarks will shift east. “Given China’s large consumption of raw materials, it is likely that benchmarks will emanate from China,” says Nicholas Forgan, head of JP Morgan’s futures and options business in Asia Pacific and chairman of the Futures Industry Association in Asia – although he says it is difficult to predict when that shift will begin.
Dean Owen, chief China representative of futures broker Newedge in Shanghai, says the CSRC believes that allowing international players into its commodity markets would be beneficial. It is just taking its time.
“Regulators and exchanges in China understand the arguments for a diversified client pool, which includes the participation of domestic as well as foreign investors,” says Owen. “But China does not have a habit of doing things in a big bang, they do things in stages. It will be progressive and orderly.”
Not every one is so confident. TieCheng Yang, foreign legal consultant and partner at Clifford Chance in Beijing, has extensive experience of China’s financial, equity and commodity derivatives. He believes a move to open commodity markets to foreign players is improbable, as unlike with financial derivatives, foreign firms are not active in the underlying markets.
If you want change in China, however, there is plenty going on. Despite its three commodity exchanges, now among the world’s largest, China has for the past decade lacked any listed financial derivatives — until now.
The country made its first move in this direction in 2006 with the launch of the China Financial Futures Exchange. This was a joint venture between the three commodity exchanges and the stock exchanges of Shanghai and Shenzhen.
The first intention was to launch futures on a stockmarket index. But as the years passed, eagerness for the contract gave way to scepticism that anything would ever happen.
That all changed in January when the CSRC announced in a curt statement on its website that CSI 300 Index Futures had been approved for launch at the CFFEX. The CSI 300 is the most followed index of 300 leading stocks in Shanghai and Shenzhen.
There was a mixed reaction to the news. Some thought it was yet more proof of the slowness of change in China — given that the contract had first been proposed nearly a decade before. Owen took the opposite view, believing that the timing of the listing was “perfect”.
Only for the few
Once again, regulatory barriers around the market are high, so that only what the authorities regard as the right sort of market participant can use the contract.
What frightens them, China-watchers believe, is the possibility of rampant speculation.
Having seen the huge run-ups and crashes in Chinese stocks this decade, the authorities are very anxious not to make matters worse. Index futures, they hope, will be used mainly by hedgers rather than speculators.
Hence only Chinese firms (and, from an as yet unspecified date, QFIIs) are eligible, and even for them it is costly. Every retail investor is required to pay a Rmb500,000 ($73,000) deposit. Yet, according to the China Securities Depository and Clearing Co, less than 3% of investors in ‘A’ shares have that much money in their trading accounts. This means the vast majority of retail investors are unlikely to have the resources to trade in index futures.
In addition, trading is done on pre-margin at a rate of about 15% the contract value, which is calculated from the CSI 300 index (currently fluctuating around the 3,000 mark) multiplied by Rmb300. (The actual margin is 12% but broker fees increase the figure to 15%-20%.)
With the index at 3,000 this means a single contract is worth Rmb900,000 ($132,000). Compare that with about Eu25,000 for a Euro Stoxx 50 Futures contract at Eurex.
At 15% this equates to a margin of Rmb135,000 per contract in a country where the average annual urban income is less than Rmb40,000 and some half a billion people still live in the countryside.
Blaze of activity
The restrictions on the new index futures are so tough that some observers expected a damp start to trading. They couldn’t have been more wrong.
The contract went live on April 16 and immediately enjoyed substantial success. Trading on the first day totalled 58,500 lots. The following day volume was 124,000 contracts, the next 153,000.
Faure says that after just two days, the contract had proved a success. As he puts it: “The volume on the first day was good, the volume on the second day was extraordinary.”
In the first five days of trading, FOW estimated, the notional value of contracts traded amounted to roughly Rmb572bn ($84bn).
For comparison, in March, the Euro Stoxx 50 Index Futures contract at Eurex traded an average of Eu39.6bn ($53bn) a day. That means that in its first week, the new Chinese contract was already trading, in cash terms, about a third as much as the Euro Stoxx 50.
On May 21, as this article was completed, the cash volume in CSI 300 Futures was almost 40% of the volume in Euro Stoxx 50 Futures.
It is clear that the CSI 300 is already one of the world’s most important equity index derivatives.
Door creaks open
Though QFIIs remain excluded from Chinese derivatives, the door may soon be opened, though only for the new CSI 300 contract — and even then only to hedge exposure that each firm may have in the underlying ‘A’ share market.
“According to discussions between the regulators and the QFIIs, foreign participants will be given a quota to trade the new CSI 300 futures,” says Yang.
While no specific figure has been floated, the number of trades the QFII will be allowed to execute will be a percentage of its existing quota permitted by the CSRC.
Yang says it is too early to say when this relaxation might happen, though other market participants believe it could come this year.
Chinese market participants were taken by surprise when the Chinese and US economic delegations’ joint statement on May 26 announced: “China will permit qualified foreign-invested firms duly incorporated in China to carry out stock index futures business in accordance with relevant laws and regulations and will allow QFFIs to invest in stock index futures products.”
Apart from the timing, however, the decision had been expected. The CSRC had in April issued draft guidelines for letting QFIIs into the index futures market. These suggest that QFIIs will only be allowed to use the futures for hedging ‘A’ share positions, though it is not clear what kind of positions may be hedged.
It is also unclear how many contracts foreign firms will be able to engage in. “The index futures contract value shall not exceed the approved QFII quota on the end of each trading day,” read one condition of the CSRC proposal, while the third read: “The index futures contract value shall not exceed the entire investment quota on the end of each trading day.”
Commodity exchanges smash record after record
China discovered derivatives in a big way in the early 1990s. In fact, too big a way. New exchanges — some 20 in all — were opened with wild abandon. But instead of the new financial products being used for hedging risk, they were used as speculative tools. The result: frenzied growth was accompanied by rampant abuse.
And with abuse came the inevitable clampdown by the China Securities Regulatory Commission. The result was that, until very recently, there were only three authorised exchanges — all state-owned — and the number of permitted contracts was also limited.
The three survivors — the Zhengzhou Commodity Exchange, Shanghai Futures Exchange and Dalian Commodity Exchange — each offer a different portfolio of commodity futures.
Until recently, the SFE was China’s smallest commodity exchange. That changed when it introduced its Steel Rebar (reinforcing bar) contract at the end of March 2009.
This proved so successful that SFE has become the country’s largest exchange. From launch until the end of 2009 the contract notched up some 162m trades, making it the most successful new futures contract launch ever. Apart from the tiny Nasdaq OMX Futures Exchange, SFE was the world’s fastest growing exchange in 2009, with volume expanding by 210%.
The second largest exchange is the agriculture-focused DCE, where volumes have grown steadily since the early 2000s. In 2009, the exchange hosted trading of 383m contracts, 31% up from 293m the year before. The exchange’s flagship contracts are Soy Meal Futures and Crude Soybean Oil Futures.
The big success story for the DCE last year was the launch of its Polyvinyl Chloride Future at the end of May which, with a volume of 16.8m contracts last year, was the second most successful new contract introduced worldwide in 2009.
Volume at the ZCE ticked up only slightly in 2009, from 223m contracts in 2008 to 227m. The volume was supported by White Sugar Futures, which have dominated activity since the exchange started. Last year ZCE launched its Long Grain Rice Futures contract. Its annual volume of 1.95m contracts made it the world’s best performing agriculture derivative introduced during 2009.
New products and rising volumes of trades propelled all three exchanges into the top 20 largest exchanges by annual trading volumes last year. SFE was the biggest climber, moving from 24th to 12th, while DCE climbed from 15th to 14th. The ZCE, despite an increase in trading volumes, slipped one place to 18th.
The quota will be decided by the State Administration of Foreign Finance, but market participants do not know whether these conditions refer to existing ‘A’ share quotas or whether the authorities will impose a separate futures limit.
Owen believes the impact of the QFII participation on trading volumes will depend on this quota. “The existing total QFII quota is less than $20bn, so if the futures limit is a percentage of that then I wouldn’t expect it to have too much of an impact on trading volumes,” he says.
While volumes in CSI 300 futures are soaring, the pattern of open interest suggests there is a lot of intraday trading.
Market commentators have suggested that Chinese traders may have adopted this approach because of the lack of hedging tools to hedge overnight movements in international stockmarkets.
Owen believes QFII firms’ involvement could raise open interest.
Though the US had pushed for the regulatory change, none of the 95 registered QFII firms headquartered in the US will be able to trade the index contact until the Commodity Futures Trading Commission gives its clearance.
Under US law, foreign boards of trade that wish to permit their US members and other participants in the country to have direct access to their electronic trade matching systems, not through an intermediary, must request no-action relief from the CFTC’s Division of Market Oversight.
Yang believes there is little chance that other foreign participants, besides QFIIs, will get access to the futures market, partly because the government is wary of firms such as hedge funds being active in its markets. Owen, too, warns against expecting any rapid liberalisation of the rules overnight.
A steady course
China’s conservative and considered approach to its commodity derivatives markets — and now its financial futures — may help it avoid the excesses that so damaged its exchange-traded derivatives industry in the 1990s.
Owen says it is clear that Chinese regulators have not been preoccupied with growing volumes, but rather with nurturing the market’s development. “Other exchanges worldwide seem to solely focus on generating volume, but that clearly isn’t the case for China,” he says. “Here, their main concern is to minimise the systemic risk that could impact the stable development of the financial industry, and to ensure that the investors are well educated and aware of the risks involved in dealing with derivatives.”
China’s own timetable of making Shanghai a global financial centre by 2020 shows that the country is playing a long game. Likewise, its slowly-slowly method of expanding participation in the new equity index future by QFIIs is described as the “next logical step” by one market participant.
“Steadily and orderly is the name of the game,” agrees Forgan. “I expect the opening of the market to be staggered,” beginning with the introduction of foreign QFIIs.
What those foreign firms will find when they finally enter the Chinese exchanges is an already hugely liquid market. “We’ve already seen some enormous volumes go through on the domestic markets – steel would be a great example of this,” says Forgan. “Liquidity is provided by a large retail market, and an institutional market which is interested in becoming more active in derivatives.”
Few involved in China have any doubt where it is all leading in the end. In Faure’s words: “China is going to be the number one ranked country by trading volume in Asia, and most likely number one in the world, in a comparatively short period of time.”