China's derivatives markets inch toward maturity

Hedged bets

China's derivatives markets inch toward maturity

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The winter of 2014 may currently be known in China as the time when Shanghai's stock prices suddenly swelled before entering what increasingly look like precarious waters, but many years from now it may be the steps taken to encourage the growth of the country's derivatives market that will be viewed as more important.

The changes received some attention in the financial press but were largely ignored in mainstream coverage, which focused on a broader narrative in which the gradual pace of economic reforms to date appeared to give money formerly monopolized by the property sector little option but to re-enter China's equity market when domestic real estate entered its slump last year. For now, regulators' apprehension at more quickly introducing derivatives still outweighs any fears of an economy hobbled by the absence of these useful financial tools—but they are being rolled out nonetheless.

"I think from Chinese regulators' perspective, they want to ensure that different players in the market are equipped with all the necessary tools so they can do their business properly and efficiently, but also mitigate any tendency to speculate," Howhow Zhang, head of research for consultancy Z-Ben Advisors told China Economic Review. Zhang suggested that while not having certain derivatives on hand to hedge against risk has and will continue to pose a long-term handicap for China's financial system, the slow pace of their introduction has its own cautious logic, as Chinese investors tend to rush into new investment opportunities.

Zennon Kapron, founder of market research firm Kapronasia, said the steady introduction of derivatives by regulators was itself worth noting. "There hasn't been one specific product launch that has caught our attention more than any other," Kapron said. "What is impressive to us is the general continued push and launch of derivative products, which is a clear indication from the regulators and government that they feel they are a necessary part of financial markets in mainland China."

Put simply

A derivative is a private contract between two parties that redistributes their financial exposure to the possible risks and rewards of a certain asset, such as stock in a company. This redistribution is accomplished by stipulating specific conditions under which payments must be made from one party to the other, and doesn't require that the asset in question immediately change hands. 

One of the simplest derivatives is the basic forward contract, in which two parties agree to make a transaction in the future using a price agreed upon now. A forward contract can allow, for example, farmers to lock-in the sales price of a crop with distributors to hedge against a pre-harvest price collapse. But that arrangement also means only the distributors will benefit if there is a price hike. That is exactly the sort of possibility that makes derivatives so seductive to savvy speculators. It is also why Chinese regulators have in recent decades refrained from introducing such financial instruments to mainland markets at a quicker clip.

Still, the rate of derivatives' introduction appears to have quickened in recent months. In late 2014 and early 2015 China saw a number of derivatives markets begin to heat up—and not always as authorities had planned. A clearer understanding of how and why is key to better knowing what to expect next from both regulators and the market.

Forwards

Forwards, which are traded off-exchange and often come highly customized, have been introduced gradually in a variety of sectors in China, with the latest progress coming in the form of the extension of permitted forwards trading to three new currencies in late December: Russia's ruble, the New Zealand dollar and Malaysia's ringgit. In October Reuters quoted an unnamed senior figure at the Shanghai Gold Exchange as saying its international board might introduce gold forwards within the next six months to a year, but to date there is still a ban on trading in commodity forwards in place on the mainland to guard against speculation.

Futures

Futures are exchange-traded contracts in which two parties agree to make a future transaction using a price agreed upon now. Futures contracts are exchange-traded and thus more standardized; they also require both parties to deposit some collateral to cover potential credit risk with a clearing house that will cover the loss for one party if the other defaults, theoretically decreasing risk.

Late December saw China's meager government bond futures market relatively revivified with reports of the debut of draft rules for trading 10-year bond futures. That might not make waves in more developed markets, but the mainland's only other offering is five-year bond instruments, and those only hit the market in 2013. Today five-year bonds are still the only tradable bond futures introduced since 1995, when a scandal prompted regulators to simply stop debt futures trading for nearly two decades. Even those currently on the market aren't available for trading by anyone but securities and futures companies.

Stock index futures launched on the mainland for the first time in April 2010. Commodities have seen greater progress on the futures front lately, perhaps in part thanks to Beijing's desire to bring the price-setting center of gravity for certain resources into Chinese orbit. The Shanghai Gold Exchange launched an international board in September last year, with a crude oil futures contract expected to follow.

Options

Among the most valuable derivatives available to investors in more mature markets are options: contracts in which one party purchases the right to buy or sell an asset from or to another party for a specific price before a certain date. But until late last year there did not appear to be any plans to introduce trading of stock or other options to mainland exchanges.

That changed in late October when the Shanghai Stock Exchange suddenly announced it had finished technical preparations for stock options trading. Hu Ruying told The Financial Times the exchange was waiting for regulators to fire the starting gun, but that "control of the trigger is not in our hands." More progress came in January when the bourse announced it would begin simulating trading of stock options on the Shanghai 50 exchange-traded fund, according to another FT report. Kapron suggested that once the trial starts in February it "could reasonably be expected to expand to a larger basket of products over the course of the next year."

Swaps

Swaps are contracts in which in which two parties agree to exchange cash flows produced by their respective assets for a fixed period of time. Interest rate swaps, in which two parties agree to exchange cash flows from the interest of a fixed rate loan and a floating rate loan, seem to have fallen off the radar for both regulators and investors, said Z-ben's Zhang. Fixed income investment is currently possible by trading in bond futures, but there appears to be little indication of when swaps might see an official launch.

Meanwhile, currency swaps have seen greater expansion in recent months as authorities have continued to push the internationalization of the yuan. The same expansion of forwards trading of the Ruble, ringgit and New Zealand dollar in late December also applied to currency swaps with the yuan, which brought the total possible swaps for the currency on China's interbank foreign-exchange market up to 11.

Synthetics

Synthetics combine features from other assets to simulate another financial instrument, and synthetic stocks—which are designed to provide financial exposure to an equity without conferring actual ownership of it—are on the rise in Hong Kong thanks to complications with participation in the Hong Kong-Shanghai Stock Connect.

Many foreign investors have wanted to take advantage of the Shanghai exchange's rally through the linkup, but ongoing barriers to direct participation in the market linkup include the limited pool of approved A-share stocks available, regulatory barriers for offshore participants and confusion over ownership of stocks traded on the connect. Although one of the goals of the linkup was to dampen interest in off-exchange financing, the current bottleneck has prompted impatient investors without access to approach those who do to help increase their exposure to Chinese shares.

As reported by Reuters in late December, funds are buying products known as p-notes that entitle holders to the performance of a mainland stock or stocks actually held by a qualified brokerage with access to Shanghai-traded A-shares, whether as a government-approved, qualified direct investor or through the Stock Connect in Hong Kong. Equity swaps, in which two parties agree to exchange future cash flows, have also taken off. But in neither case is data available on trading volume or value, making the scope of these developments hard to pin down.

"Certainly there has been renewed interest in anything mainland stock-related as the mainland continues on its recent bull run," said Kapron, but he added that "synthetic equity will gradually be less important as rules and requirements around the HK-Shanghai Connect are relaxed and the program continues to expand in the future."

That trend may already have surfaced, with one example found in the recent performance of one prominent synthetic China exchange-traded fund (ETF). A synthetic ETF is a derivative intended to provide exposure to an investment fund which is traded on an exchange, like a stock. These funds usually track an index like, say, the S&P 500. But while that index allows for global investor access, China's onshore stocks have only just begun opening up.

BlackRock Inc's iShares FTSE A50 China Index ETF, created in 2004 to mimic mainland shares and listed on the Hong Kong exchange, underperformed its target in 2014 by around 4.3%, according to a recent Bloomberg report. Meanwhile, rival CSOP's own FTSE China A50 ETF, which was created in 2012 and buys mainland shares directly rather than simulating their performance, trailed its own benchmark index by only 2% last year. In a straightforward competition to broadly simulate Chinese markets' behavior for investors, that makes CSOP's fund the clear winner.

But synthetics won't necessarily disappear as capital controls ease; the introduction of other derivatives onshore could sow the seeds of home-grown synthetics on the mainland. The recipe for a plain vanilla synthetic equity, for example, is to buy a call option and sell a put option on the same stock, creating a position that replicates the performance of shares in a given company without necessitating ownership in it. This could in turn foster an increase in the kind of murky financing that Beijing so detests.

A thirst to be diverse

Whatever order future derivatives are introduced in, it seems likely they will be snapped up as fast as they can be spun out thanks to diversification-starved local brokers. Zhang, at Z-Ben, suggested that Chinese investors and institutions had a natural tendency to jump onto any fresh asset classes thanks to an intuitive understanding of a portfolio's need to include a wide variety of investments. That may further hold up the introduction of derivatives in China, even as domestic demand remains strong.

"That's why people always attach a premium to these newly introduced asset classes," Zhang said. "You probably are going to have another wave of excessive demand if those derivatives are offered to Chinese as a product class."

As financial reform continues its measured pace on the mainland, derivatives will continue to be tolerated by the government as an unpleasant necessity—one best kept at arm's length. Whatever their class, they will be welcomed by regulators for their role in hedging against risk, yet still viewed in equal measure with suspicion as potential tools for speculation in a wide variety of markets that could, if left unchecked, introduce more fiduciary danger than ever.

That is exactly the kind of risky business that Beijing wants its bourses to have no truck with. It is also where savvy investors should keep an eye trained to take advantage of the next big derivatives boom as China's underserved markets strive to diversify. ♦


Author: Hudson Lockett (@KangHexin)