Euromoney Chinese futures report: index futures

Euromoney, June 2010

On August 16, the development of China’s futures exchanges took a significant step forward. That day, the first index futures contracts in the country began trading on the China Financial Futures Exchange in Shanghai. They became the first financial futures ever to trade in China, and mark the start of what is likely to be a major new market – one that, if China’s other futures markets are any guide, will become a world leader in volumes one day.

Commodity futures have been around in China for many years and are discussed in more detail in the next article. Although relatively young – the oldest established contracts date from 1993 and some are barely a year old – they have in many cases become world leaders. The Dalian Commodity Exchange is a world leader for a number of soybean and plastics contracts; the sugar contract on the Zhengzhou Commodity Exchange is the most widely traded agricultural future or option in the world; and the Shanghai Futures Exchange last year overtook the London Metals Exchange to become the world leader in copper trading volume, an extraordinary achievement for an entirely domestic exchange. What’s more, all are growing at a staggering rate, with a great many contracts on track to double their 2009 volumes in 2010.

But the significance of the new index futures is that they are financial products rather than commodities. “For the past 16 years there have only been commodity futures,” says Kathy Xu, who covers international business at Shenyin & Wanguo Securities in Shanghai. “Index futures will be a very important start for financial futures products in China.”

They matter because of the opportunity they give traders to take a view on the Chinese market. “In the securities market China does not have any short selling system,” she says. “Now we have index futures, that means investors can sell, so they have a shorting mechanism. In the past investors could only make money by buying stocks, and if the market fell, they lost money. Now it’s different, and that is very important for investors – retail and institutional.”

Janet Kong, Managing Director and Head of Commodities Research at CICC, agrees. “I used to work on the buy-side, and we used to talk about how the information ratio of an investment manager cannot be improved without relaxing the shorting constraints,” she recalls. “A manager needs to be able to buy a stock to express a positive view, but also to short a stock to express a negative view. These constraints eliminate half the universe for a manager to improve their information ratio.” Being able to do so now, she says, “helps them to add alpha for investors.”

The new index futures, based on the CSI 300 stock market index, follow four years of effort that demonstrate how China takes its time to ensure it gets things right. The CFFEX itself was formed in Pudong, Shanghai, in September 2006, as a joint venture between China’s three other futures exchanges – in Zhengzhou, Dalian and Shanghai – and the Shanghai and Shenzhen stock exchanges. Mock trading of CSI 300 index futures dates back to October of that year, but the State Council waited more than three years, to January 2010, before granting formal approval for the introduction of stock index futures in principle. In that time, a host of brokers were vetted and eventually approved to be clearing and trading members – today there are 128.

The State Council’s approval of index futures was part of a broader advancement of market tools. On the same day it approved index futures – January 8 – it also announced approval for a new margin trading pilot programme. “The margin trading and index futures programmes will open up the attractive hedging option for all kinds of investors in the market,” says Ivan Shi at Z-Ben Advisors, a leading Shanghai-based research group focusing on the Chinese asset management and financial markets industries. He counsels against reading too much into them: “The pilot stages are designed to contain potential risks and uncertainties to the minimum. For financial institutions, watching, trying and learning and the feasible choices at present.” But that is the local way, and still hints at a major new market. “It is paramount at this stage for CSRC to ensure a successful start for these tools,” he says. “Any experience and lessons learnt now will contribute to the perfection and further expansion of margin trading and index futures platforms in the future.”

Index futures have started strongly, with an average daily volume of 130,000 contracts in the first three weeks of trading, with a high of 190,000 and open interest of 13,000 contracts. “Since their 16 April inception, CSI 300 futures have become one of the most active contracts globally, with average daily turnover of RMB117 billion,” said Goldman Sachs analyst Jason Lui on April 26, scarcely more than a week in to the new contract. Lui says that figure is equivalent to 57% of the overall Chinese A-share daily turnover, and more than the total daily turnover of the CSI 300 constituent stocks themselves. It already ranks second in the region after the KOSPI200 contract in Korea (popular with Korean retail day-traders), and has outstripped the HSI contract in Hong Kong and FTSE 100 in London.

But that’s just the start. These volumes come purely from retail investors, as precise guidelines for institutional use are still under development. On April 23 the CSRC finalised trading regulations for domestic brokers and mutual funds, and once they are implemented and those institutions can trade, volumes will go up significantly, particularly since qualification standards appear to favour institutions over retail. Retail investors must have at least RMB500,000 in usable capital in margin accounts, and must show trading experience, either in mock trading of index futures, or for real in commodity futures markets. That’s reasonably restrictive. Institutions, on the other hand, have a minimum net asset requirement of RMB1 million – hardly a hurdle at all for an institution – alongside other practical stipulations such as a proven internal governance system. “It is apparent to notice, in this design, a bias towards institutional participation from the regulators,” Shih says.

The exchange itself confirms this. “We hope that China’s stock index futures market is dominated by institutional investors or sophisticated investors,” an exchange spokesperson says. “We adhere to the view that the main purpose of the product is to help them hedge market risk, this giving full play to its function of risk management.”

The exchange hopes that index futures will “enhance the mechanisms of the stock market, and improve the market’s operation.” It isn’t launching futures to help speculation: instead it has very specific hopes for what they will achieve.

Firstly, the exchange views index futures as an “internal stabilizer mechanism” for the stock market. By this, the exchange means that the presence of these futures should dampen volatility. It also hopes futures will help build price-forming mechanisms, and allow them to hedge risks, which has previously been exceptionally difficult in the stock market in China. Finally, the exchange hopes that the existence of index futures will help to build a mature group of institutional investors for the stock market – something which usually helps the market itself behave in a more steady, balanced and predictable fashion. “Giving institutional investors access to the futures market will help promote growth in the open interest and diversify the market away from retail day traders,” says Lui at Goldman Sachs.

Speculators, by contrast, are discouraged, as they have been in China’s commodity exchanges. “For speculative investors, there are strict limits on the number of positions they can hold,” Shi says. “The maximum number of a contract is 100 on a single direction, which is far lower than the market expectation of 600. Investors with hedging purposes, on the other hand, need to apply to the China Financial Futures Exchange for position quota, which is usually much larger than the position limits for speculative investors.”

While the guidelines that would allow mutual funds, securities firms and other institutions to invest are eagerly awaited, there is a still more significant set of guidelines to follow: those governing QFIIs, or qualified foreign financial institutions. QFIIs have been allocated quota to invest in China’s stock markets under certain conditions (such as not repatriating their capital outside of China), and by the end of 2009 US$17.07 billion of quota had been granted to these foreign institutions. But they have never been permitted to invest in futures.

There seems little doubt, though, that QFIIs will soon be permitted to trade index futures domestically; the regulator, the CSRC, is understood to have compiled draft measures already. “It is a very significant step for foreign investors to be able to participate in the futures market in China,” says Xu.

The CFFEX confirms this is underway. “Currently QFII can invest in the stock market of Mainland China,” the exchange says. “In the future, the regulators will formulate rules about how QFIIs can trade index futures, with the purpose of providing hedging instruments for them.”

When foreigners are allowed in, given the level of interest in Chinese securities from overseas, volumes on CFFEX are expected to show even more impressive growth, although opinions do vary on what the impact will be. “In Taiwan, for example, QFII investors are more active in terms of their participation in the futures market than domestic players,” says Dr Huang, Managing Director and Head of Sales and Trading at CICC. “I hope this is the case in mainland China: QFII investors will hopefully be very active investors in the market.” Institutions like CICC will certainly hope so – CICC has about a one third market share in serving the needs of QFII investors and stands to benefit from a lucrative new business line as they engage in index futures too. “We are talking with them, and like us, they are looking forward to participating in a new market,” Huang says of QFIIs already in China.

Janet Kong, though, argues that foreigners won’t necessarily bring bigger volumes with them. “If you look at cash equities, turnover is about half and half retail versus institutional, and of the half belonging to institutional trading, it’s dominated by domestic mutual fund managers, not QFII,” she says. “The QFII turnover rate is much less than at domestic managers. And if you’re just using index futures for risk hedging, then the pattern will probably be the same: the lower turnover will carry through to futures trading as well.”

(Whether foreigners will one day be permitted to invest in commodity futures is a different story, and divides opinion. In almost 17 years, they haven’t been permitted yet. “This time, with index futures, the regulators have decided to change the situation because QFIIs have cash market trading in the securities market, and need to be able to hedge their positions,” Xu says. “For QFIIs to be able to trade commodity futures, the regulators would need to modify the law – and I don’t think it will happen in the next few years.” See the next article for more on this.)

The development of index futures doesn’t necessarily create a new business stream for foreign banks though, and they have tended to be hesitant about commenting. “HSBC currently does not have the right to do China index futures – it would require a JV with a Chinese financial institution,” says a spokesperson there, adding that comments would therefore be hypothetical and inappropriate. It may, though, represent an opportunity for those foreigners who have managed to negotiate brokerage as part of their securities joint ventures in China: Goldman Sachs, UBS and CLSA.

Both UBS and CLSA declined comment, but Goldman is already putting out quite detailed research on the futures contract and making positive noises. “We would expect this to be not only a dominant index futures contract in China, but in time, it has the potential to become one of the region’s most liquid contracts,” said Christopher Eoyang, a Tokyo-based Goldman Sachs analyst, in a report timed for the first day of trading on April 15. “We are encouraged by the prospect of a well-designed equity derivatives contract in the Chinese domestic market. Although we anticipate the ramp-up period to be conservative and gradual, we expect the CSI 300 index futures contract to contribute to the deepening and maturity of the Chinese domestic equity markets, and look forward to the time when QFII investors are also permitted access to the contract.”

Foreign banks do, though, see a certain reflected opportunity. Deutsche Bank, for example, launched 11 UCTIS-compliant China A-share exchange-traded funds (ETFs) on March 25 in Hong Kong, all of them based around the CSI300 or its various sector indices. While index futures don’t technically impact these ETFs, their launch is still good news for Deutsche as it raises awareness of the indices themselves. “We are not directly impacted by the turnover in futures, because the Chinese market is not connected to the Hong Kong one, but the fact that we launched our ETF on March 25 and futures were launched on April 16 has of course helped us to market,” says Marco Montanari, Asia head of Deutsche’s ETF platform, db x-trackers. “The fact CSI 300 has been chosen for the first index futures in China is very important to us.”

He sees the launch of futures as momentous. “It’s a positive development for the market, and any instrument that can be used to hedge exposures for investors is a good thing,” he says. “If we are one day able to use it as a hedging instrument, it will help to offer even better market-making conditions to foreign investors.” For an ETF provider this would make quite a difference. “Instead of buying the standard stocks, you could just buy the future as a hedge. This would of course make our life easier and improve the conditions of final investors in our ETF.”

The CFFEX has started out with the CSI300 index, probably the most closely watched index in China, but there are several others that would lend themselves to index futures too. The CBN 600, for example, is the one quoted in the Wall Street Journal every day; others that are closely followed domestically are the Shanghai Composite Index and SSE50. “After the CSI 300 Index futures are launched, we will provide more financial futures or options products according to demand – and, of course, with the approval of the regulators,” the exchange says.

Kong at CICC, expects a steady evolution “when the regulators become more comfortable with the operations of index futures. The first step may be access to more institutional investors; the next step may be to offer futures or options on individual stocks, to give investors more flexibility to express their views.”

Kong’s colleague at CICC, Dr Huang, looks still further ahead. “I think there will be many more products to be developed, and another innovation would allow lending and borrowing in stock. Then I think China can develop its own hedge fund industry.” This would be a major step: while there are funds in China which express an absolute return philosophy, the inability to short means that hedge funds in any western sense – where the term is most commonly applied to long-short funds – do not really exist. “This is where I think index futures substantially change the landscape of the money management industry in China,” he says. “China is still a largely incomplete market, where many products are not fully developed. So this is a milestone for China’s capital markets development.”

BOX: How’s it doing so far?

The CSI 300 index has already shown some interesting characteristics. The exchange says that in its first three weeks average daily volume was 130,000 contracts, and open interest 13,000; brokers say that early average trading volumes in value terms were around RMB117 billion notional, which is one of the leading contracts worldwide and represents 57% of the average daily turnover of the overall A-share market.

After 10 days of trading, Goldman Sachs opted to look more deeply into trading patterns, and noted several traits:

• Index futures trading volume often reaches 50% of the cash market within the first six to 12 months of trading. The CSI 300 contract managed it within the first 10 days.
• More than 90% of CSI 300 futures trading so far has been in the front-month contract – that is, at launch, the May 10 contract. In the first 10 days of trading, 93% of volumes went into this contract, 5% into June 10, and 1% each into September 10 and December 10. This, says Goldman’s Jason Lui, is “similar to global patterns.”
• Open interest is dramatically lower the trading volume. When Goldman looked, in notional terms, open interest had reached only RMB7 billion, less than 5% of average daily volume. The exchange says that in the first three weeks of trading, open interest contracts were 13,000, just 10% of total daily volume by contract numbers. “Open interest is a useful measure for the growth of futures contracts because it reflects the level of long-term investor exposure in the market,” Lui says.
• Trading distribution shows volume picks up in the afternoon, which perhaps reflects the presence of retail investors. “We suspect this is partly caused by retail investors starting to close their intra-day positions,” Lui says.
• Goldman says all four CSI 300 futures contracts (May 10, June 10, September 10 and December 10) have been trading at premiums to fair value.
• CSI 300 futures have the largest mispricing of regional peers. Lui says this is “understandable due to its short trading history and the current conservative operational environment. Over time, the magnitude of CSI 300 futures mispricing should decrease as trading volume becomes more balanced (retail speculation versus institutional flow) and the operational environment becomes more flexible.”