Investors see opportunity in Chinese futures reform

Jeremy Wright, Global Head of Futures and Options

While China has set no timetable for the liberalisation of its capital markets, a series of initiatives in recent years suggests the pace of reform could gather speed as we move into 2013. Moves to liberalise its markets will pave the way for the convergence of the offshore and onshore pools of the Chinese currency. And, with a change in the country’s leadership due this year, investors are eagerly awaiting the next developments.

Chinese regulators remain cautious about the explosion in trading volumes. Last year the China Securities Regulatory Commission (CSRC) raised concerns that significant growth in the futures market was fuelling inflation and intervened to reduce volumes. Trading has remained at a consistent level throughout the year.

In 2011, the CSRC started to look at further ways to internationalise the China index futures market. In May, it published legislation allowing approved foreign investors, known as Qualified Foreign Institutional Investors (QFII), to trade stock index futures with certain restrictions. This has the potential for significantly increasing foreign participation in China’s financial futures market, but up to now no QFII has been able to take advantage of this opportunity, because of restrictions on opening currency accounts.

The QFII program had been originally launched in 2002 in China to allow licensed foreign investors to buy and sell yuan-denominated ‘A’ shares in the country’s mainland stock exchanges in Shanghai and Shenzhen. Then, in May last year, QFIIs were given permission to start trading futures - but only for the purpose of hedging their equity portfolios.

The value of futures contracts traded on an inter and intra day basis must stay within their investment quotas, which are valid for six months at a time. They can trade long or short positions on multiple contracts as part of this, but no individual or corporate investor can hold more than a 100-lot position.

The amount they can hedge is set on a nominal basis and is not set at a specific percentage of the total investment quota. With no QFII participation, the impact of this is, as yet, unclear. Before the quota is set, the China Financial Futures Exchange requires QFIIs to provide a plan indicating their hedging needs, including their stock holding and cash positions.

All this is time consuming and requires a considerable amount of administrative work. However, the main reason why no QFIIs are actually trading the CSI 300 futures is because of a conflict with the central bank’s currency controls. The People’s Bank of China only permits QFIIs to have one local currency account. Yet, in order to trade futures, the QFIIs have to set up a second RMB account for futures clearing. The PBOC reportedly is drafting rules that will solve this problem by allowing QFIIs to open a second RMB account, but until this is done, the market cannot develop.

Once they do start trading, QFIIs will be able to choose up to three Chinese domestic futures companies with which to conduct their index futures trading. Whether they use clearer or execution brokers, the number of brokers cannot exceed three.

At present, futures trading centres on four futures exchanges - the China Financial Futures Exchange, the Dalian Commodity Exchange, the Shanghai Futures Exchange, and the Zhengzhou Commodity Exchange. The regulators have permitted trading in 25 commodity futures and one stock index futures contract.

The market is dominated by retail flow and the most actively traded contracts are futures on sugar, steel, copper and rubber. Local retail clients and pooled retail hedge funds are the biggest players, but local corporates and exchange-traded funds also play a part. Foreign corporates with onshore subsidiaries also trade in commodity futures, but this is a small percentage of the total volumes traded. Institutional clients, such as the proprietary trading desks of securities companies, are active in the stock index futures market, but are not permitted to trade commodity futures.

While brokers wait to see how the onshore market develops they are also looking at China’s outbound futures market. In 2006, six brokers were approved by CSRC to establish branches in Hong Kong. These branches are allowed to acquire licenses from Hong Kong’s Securities and Futures Commission and the CSRC to solicit business in Hong Kong, including from Chinese clients based there. In effect this has paved the way for Chinese institutions to have exposure to international markets across a number of capital market products.

In the past year, two Hong Kong-based subsidiaries of Chinese firms have joined leading international exchanges. For example, Nanhua Futures became a trading participant of Eurex in April, and GF Futures became a trading member of NYSE Liffe in July and a trading member of SGX’s derivatives market in August.

Now under discussion in Beijing is the possibility of expanding this channel to the outside world. The CSRC is drafting rules that would permit domestic brokers to trade on the international markets from within China and many expect this to come to fruition this year. The CSRC reportedly is close to selecting a handful of firms to participate in a pilot project.

One of the benefits of such a move would be to increase the sophistication of the domestic brokerage industry. There are 31 state-owned Chinese companies that are allowed to trade futures on overseas exchanges for hedging purposes. Up to now these firms have relied on international futures brokers to handle this business. A change in policy would allow domestic brokers to compete for this business and gain more experience with international market practices.

One of the participants in the pilot project may include one of the six brokers who have branches in HK or the three international joint ventures operating in the China futures market. The three foreign brokers that currently have futures joint ventures in China are J.P. Morgan, Newedge and The Royal Bank of Scotland Group.

Galaxy Futures, the partnership between RBS and Beijing-based China Galaxy Securities, was the first joint venture futures brokerage business to be established in China. It is a clearing member of all four exchanges and is the only joint venture to receive an ‘A’ rating from the CSRC. Galaxy Futures has also obtained CSRC approval to carry out trade advisory business.

For RBS, the joint venture is one of the cornerstones for the bank’s China strategy. The joint venture offers RBS clients with QFII licenses the ability to access the China Securities Index futures market. RBS will also be the sole counterparty broker for Galaxy Futures for all outbound futures markets, a business that is expected to grow significantly as the authorities continue implementing the reforms.

RBS has invested significantly in the business and has plans to grow it considerably. RBS is advising and working closely with Galaxy Futures management on risk, operations, IT infrastructure and compliance matters. RBS also hosts regular training sessions at Galaxy Futures in Beijing and Shanghai.

We believe the opportunities are huge for the futures market in China and will therefore continue to work closely with the leadership team of our Chinese partner. May’s legislation was one step on the path to the internationalisation of the country’s domestic market and there are likely to be more to come in the not-too-distant future. This will encourage more sophisticated investors to enter the market, which, as a result, will grow in complexity and depth.

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