Euromoney Chinese futures report: commodity exchanges

Euromoney, June 2010

It tells you a lot about China that many of its commodity futures contracts have become world leaders despite the fact that they are entirely domestic. No foreign money is allowed to participate in them; only locals can trade them. Yet in copper, plastics, rubber and a host of other areas, Chinese futures volumes are dominant.

China’s commodity futures market dates from a pilot trading program at the end of the 1980s. As with any new venture, it was not immediately successful: dozens of exchanges sprung up, many of them under local governments, and speculation and market abuse was widespread. China twice tried to grab the industry by the scruff of the neck, first in 1994, when the State Council took over 50 futures exchanges and turned them into 15, delisting a host of contracts. It began issuing formal licences for brokers, restricted trading on foreign futures exchanges, put the local exchanges under the control of regulators rather than local governments, and introduced new rules and regulations.

The 1994 changes helped, but didn’t fix the market, so the State Council had a second attempt in 1998, which created the landscape you still see today. Most of the 15 surviving exchanges were closed, restructured or merged, leaving the three that still control commodities trading today: the Shanghai Futures Exchange, which was formed from a merger of the Shanghai Metal Exchange, Shanghai Foodstuffs Commodity Exchange and Shanghai Commodity Exchange, beginning life in its new legal form in December 1999; the Dalian Commodity Exchange; and the Zhengzhou Commodity Exchange. Most contracts were axed – just 12 survived in 1993 – and the number of brokers fell from around one thousand in the early 1990s to 175.

From that foundation, the industry has thrived, and the Chinese state today tends to see that period as the real basis of the modern futures market. Yang Jiang, Assistant Chairman of the China Securities Regulatory Commission, explains elsewhere in this guide: “In the new century, the Chinese government put forward the strategic thinking of: ‘steadily develop the futures market’, which pointed out the direction for the development of China’s futures market.” See his interview for more detail on some of the key regulatory changes during that time, notably State Council opinions and regulations in 2004 and 2007.

With it, the whole appeal of China’s futures market as a credible method of risk management has grown. “Back in the 1990s, some incidents tarnished the name of commodity futures and people perceived the traders as being more speculative than having any real needs,” says Janet Kong, Managing Director and Head of Commodity Research at CICC. “But in recent years, from the regulators to the government to the exchanges themselves, there has been a lot of investor education around the country telling people that futures can be an important thing to manage risk. That awareness helps.”

Exchanges themselves are delighted with their new environment. “After decades of development, the futures market has entered a period of sustained and healthy development,” says Liu Xingqiang, president of the Dalian Commodity Exchange. “The futures regulatory environment has greatly improved.”

BUILDING THE INFRASTRUCTURE

Liu says this improvement is embodied in three ways: legal environment, regulatory environment and supervision by public opinion.

“China’s futures market has gradually improved and perfected its legal and regulatory system,” he says. This is underpinned by the Futures Trading Regulations, a foundation upon which other key rules such as the Futures Exchange Regulations and Futures Company Regulations have been developed. “These documents included the regulation and normalization of the relevant futures exchanges, futures companies and futures executives,” he says. “At the same time, it also established the futures margin deposit system, investor protection fund system and a series of other basic systems.”

On the regulatory side, Liu speaks of the building of a “five in one” regulatory model. In 2000, China established a self-regulating futures organization called the China Futures Association, to strengthen management and self-regulation of the growing futures industry. By 2006, the China Futures Margin Monitoring Centre was established to improve margin deposit management, and from this evolved the five-in-one model Liu refers to: the China Securities Regulatory Commission (CSRC), the CSRC Agency, the futures exchanges, the China Futures Association and the margin monitoring centre. “This model has helped to achieve control over the entire process of futures regulation.”

“Finally, in terms of supervision by public opinion, the media has begun to play a significant role in the regulatory system,” says Liu. “With the continuous development of the futures market and the growing awareness of finance in society, the reporting of futures-related content in both financial and comprehensive media outlets has increased and become more standardized.” The media, he says, has been responsible for delivering and disclosing futures market information, “and in this way it has directly supervised the market through public opinion.”

And while it can seem curious from a distance to have three different commodity exchanges in operation (in fact there are now four futures exchanges, with the launch of the China Financial Futures Exchange, which is part-owned by the three commodity exchanges), those who have followed the industry over the long term consider it a sharp rationalization. “I don’t think China will continue to reduce the number of commodity exchanges, because China is such a big market,” says Kathy Xu, who covers international business at Shenyin & Wanguo Securities in Shanghai. “And among the three commodity exchanges, they trade different products. We haven’t seen a single product listed at three exchanges.”

Indeed, a look at the three exchanges shows how they have all evolved with different characters and strengths. The Shanghai Futures Exchange, whose legacy institutions include the Shanghai Metals Exchange, is still best-known for its metals, plus rubber and fuel oil. Dalian Commodity Exchange is centred around agricultural products, particularly soybean and its derivatives; and has more recently built a highly successful specialism in plastics. And Zhengzhou Commodity Exchange is pure agriculture, with its greatest success in sugar, cotton and pure terephthalic acid (PTA).

EXTRAORDINARY GROWTH

All three have enjoyed tremendous recent growth across the board, and what’s really noticeable is the pace at which that success seems to be increasing.

Take Zhengzhou. Its sugar contract was, according to the Futures Industry Association, the top agricultural future or option anywhere in the world in 2008, and by 2009 logged 292.13 million contracts worth RMB12.82 trillion in the course of the year. But look at 2010: in the first four months alone it had already shattered the 2009 full-year value, with RMB13.78 trillion – which, if continued through the year, would equate to 281% growth. 259.6 million contracts changed hands during that time; at this rate it won’t be long before China sees a billion contracts change hands in a single commodity futures contract in the space of a calendar year.

Zhengzhou is enjoying similar growth in its other key commodities. Turnover in cotton was up 82.7% in 2009 over 2008, at RMB1.29 trillion, with contract volume up 58% to more than 17 million; yet in the first four months of 2010 both the volume and contract figures for 2009 had already been comfortably eclipsed. Similarly in PTA futures, the first four months, in which RMB1.33 trillion of trades were made, represented 91.98% year on year growth.

Similarly on the Dalian Commodity Exchange – now the second largest agricultural futures market in the world by volume – volumes on its soybean meal contract (1.55 billion metric tons of turnover in 2009) and soybean oil (948.37 million tons) were in both cases well ahead of their equivalents in Chicago, traditionally considered the global leader for agricultural futures, although its contracts in soybean itself still lag Chicago. The soybean meal turnover gives an illustration of just how dramatically Chinese contracts can grow: its 310.8 million contracts in 2009 were double the figure for 2008 and 35 times the total in the contract’s first year of trading.

Another aspect of the Dalian Commodity Exchange is even more revealing. The exchange launched its first ever plastics future – for LLDPE, or linear low-density polyethylene – in 2007, following it up with a PVC contract in 2009. Yet in that exceptionally brief period of time, Dalian has become the world’s leading plastic futures market, with 126 million contracts worth RMB5.74 trillion traded in 2009. “Although China’s plastics futures market is still relatively young, the scale of its market has far exceeded that of other international exchanges,” Liu says.

In Shanghai, it’s the copper contract that has been grabbing global attention, because it has taken on one of the true heavyweights of the world’s futures markets. The London Metals Exchange is traditionally seen as the world focus for copper: clients from all over the world use that exchange either to hedge their exposures or to speculate, and have been doing so for more than 130 years. Yet in 2009, the world’s largest trading volume was not in London, or New York, but in Shanghai: 81.22 million lots. It is clearly one of the major price determination markets in the world, but extraordinarily has become so based entirely on domestic trading.

Shanghai is also the world leader for natural rubber futures, and its fuel oil contract is the next largest energy future or option in the world after the NYMEX West Texas Intermediate and Brent crude contracts. Its steel rebar and wire rod contracts are world leaders too – even though both were launched in only March 2009.

THE ECONOMIC DRIVER

It becomes easier to understand why such huge contracts volumes have been achieved in a domestic market when one considers just how active China is in the underlying commodities, both as a producer and a consumer. “China is a leading global commodity production and consumption nation,” says President Liu at the DCE. He cites World Bank statistics showing that among 16 selected bulk commodities, China is in the top three worldwide for production and consumption in 12 of them. “At the same time, China’s economy continues to develop at a rapid pace, and it has already become the world’s third largest economy.”

Some examples: China produces 15 million tons of soybeans each year – but consumes 50 million. The difference has to be imported. Another: Macquarie Bank analyst Bonnie Liu forecasts 6.6 million tons of real copper consumption took place in 2009, and expects net imports of 2.5 to 2.6 million tons of refined copper in 2010.  She also says China became a net importer of aluminium in 2009, that iron ore imports will hit 650 million tons in 2010, and adds: “Chinese zinc demand has been growing strongly since mid-2009, especially from the construction, appliance, machinery and automotive industries.”

In all industries where there is an interplay between domestic production and imports, there is a need to hedge against price movements, and this more than anything is what has driven the extraordinary growth in futures volumes. It is, in some sense, a play on the Chinese economy itself: as the economic engine grows and grows, the volumes of raw materials in play grows too, and with it a need to hedge. “The increase in volume we have seen in the commodity markets in recent years I think is due to the increasing importance of the Chinese market, especially the increasing demand for commodity products,” says Xu.

Janet Kwong at CICC adds: “It’s not until the last five years that strong economic growth has propelled China into being a global economic powerhouse. That has made China very important in commodities in particular: it consumes almost 40% of world copper and 35% of aluminum. That’s reflected in the futures commodities markets becoming more important.”

In many cases, volatility in commodity markets has been extreme in recent years, underlining the need for hedging: in 2008, for example, cotton futures prices on the Zhengzhou exchange hit both a record high and a record low in the course of the same year. In others, volatility is combined with increasing interaction between local and international markets. Soybeans are an example. “Due to the severe volatility in the agricultural products market, the growing linkage between the domestic and international soybean markets, exchange rates, shipping fees and other volatility risks have created a strong demand for hedging in the soybean crushing industry,” says Liu at the DCE. He says China’s dependence on the international economy has now passed 60%, which also feeds a need for hedging.

CHINA’S CHANGING AGRICULTURE

A close look at how agriculture has developed in China is useful in order to understand why hedging is growing and will continue to do so. “In recent years, the extent of marketization in China’s agriculture has steadily increased,” says Liu in Dalian. “This has not only created demand for specialization in production and operations of agriculture, but also created demand for farmers to obtain a sense of certainty in cultivation and sales,” he says. Agricultural futures help to create that sense of certainty for farmers, “a sense of market security,” as he puts it. For its part, the Dalian exchange launched the Village and Household Market Service Project in 2005 to provide free training to northeast Chinese grain farmers and rural civil servants; in more developed areas, it ran trials on futures styles that would fit farmers. “The purpose of these programs is to help the parties better understand the futures market, and to use the relevant prices and information from the futures market to better serve the cultivation and sale of agricultural products.”

As China’s agricultural market develops and becomes more industrialized, these themes will continue. “Rural and farmer cooperative organizations have developed together, and these organizations will help to bring together and unite the operations of many scattered farming households,” Liu says. “This there is an urgent demand for greater market information and for futures hedging.” Rural co-op leaders are now being trained on futures markets.

Unlike Chicago or London, where much trading simply follows a pattern of where traders believe they can make money, the futures available in China so far are vital to the stability of the industries around those commodities. “Our listed commodities [wheat, cotton, white sugar, PTA, rapeseed oil and early rice] are widely recognized for their functions and roles in industrial economy development,” says xxx at Zhengzhou Commodity Exchange. “ZCE cotton futures play a significant role in guiding production, consumption, and providing a reference for domestic macroeconomic policy.” Similarly, xxx at Shanghai Futures Contracts says: “All our contracts are responding to the call of China’s economic development and the needs of risk management at corresponding industries and enterprises. They have all been well tested by the market and have shown stability, functionality and received sound feedback from the real economy.”

 LOCATION LOCATION LOCATION

All three exchanges believe they are in a favoured location for further growth. Zhengzhou, for example, makes much of its central location: the crossroads between north and south, east and west, on the Beijing-Guangzhou and Longhai railways, the Beijing-Zhuhai and Lian Huo expressway, and two national highways. “In China’s economic development pattern, Zhengzhou is in a central strategic position whether it flows from east to west or north to south,” says xxx. It has China’s largest railway marshalling yard and a container transfer station supporting the shipping routes from Shanghai, Kowloon, Lianyungang, Tianjin and Qingdao. It’s also in Henan Province, whose wheat planting area and output ranks first in China; it’s a main producer for soybean, corn and cotton besides.

Dalian benefits from the Northeast Asia Revitalization plan and other state-driven programmes to revamp its surrounding region. “According to the national government’s plan, Dalian is to be positioned as a regional financial centre and as Northeast Asia’s international shipping centre,” Liu at DCE says. “These two centres will promote each other’s development.” On both counts, it should help the DCE achieve its mandate from the state, to develop “into Asia’s leading futures trading centre” and “to promote the Northeast Area’s inherent advantages and match them up with the DCE’s futures products.” Liu says that, with this backing, “our goal is by 2020 to be Asia’s largest fully-functional derivatives exchange with standardized operations, a rich product offering, advanced technology and significant influence in the global marketplace.”

As for Shanghai, the advantages of that city are clear – the key financial and markets centre of the world’s most exciting and vibrant nation.

What’s next? “Now that commodity futures have been operating in a relatively smooth mode for 10 years, a lot of consumers and producers are expressing a desire to have more futures contracts specific to their needs,” says Janet Kong at CICC. “So far you can only trade three metals: copper, aluminium and zinc. That leaves out lead and nickel, which are important to operations. If you look at their price volatility, they are no less than the other three: there is a growing industry need for more contracts to be introduced for commodity futures.”

There’s also oil. A fuel oil futures contract trades on the Shanghai exchange, but there’s no crude oil. “That potentially may be another area the exchange looks into. If you look at Chinese production, they have become an increasing importer of crude, and a major producer of refined products.” If the inputs are imported from the overseas markets, then those with approval to do so can hedge the risk in overseas markets too. But as futures contracts have developed locally, “there should be a way to hedge risk on a totality basis,” says Kong. “Over time, there should be more leeway, to hedge risk both overseas and in the domestic market.”

For their parts, the exchanges are certainly keen to do more. Liu says Dalian will continue to develop agricultural futures, and expand in plastics, and into energy futures. “Research has already been underway on coke futures,” he says. Shanghai Futures Exchange has a five-year strategic plan for 2008 to 2012 which talks about developing contracts in sequence from base metals t precious metals, energy products and chemicals. Xxx names steel, lead, silver, oil, petroleum, diesel, liquid gas, electricity, asphalt, glycol and methanol as possible underlyings, as well as “actively developing other derivatives such as options, index futures and emission rights.” In 2010, he says Shanghai will “push forward the launch of lead or silver futures, intensively focus on research and efforts to launch oil futures and options, and deepen R&D on metal index and carbon emission rights.”

Whatever contracts they decide to launch, expect them to be challenging for world-leading volumes within a year.