In Depth: China Speeds Up Expansion of Derivatives Market

As the pace of China’s financial market opening to the world accelerates, the country’s nascent financial derivatives market faces an urgent challenge to expand its offerings to meet global investors’ hedging needs.

China’s securities regulator recently approved the launch of five commodities options and three financial options, marking unprecedented measures to broaden the derivatives market. The moves are expected to attract more global investors to the China market, especially hedge funds.

The China Securities Regulatory Commission (CSRC) has made clear it aims to ease the rules in the derivatives market and increase offerings, making it more accessible and attractive to foreign investors and helping the market for A-shares to mature, a person close to the regulator said.

China had its first commodities futures option product only two years ago. Options for soybean meal debuted on the Dalian Commodity Exchange (DCE) in March 2017. Over the past two years, the number of commodities covered by futures contracts expanded to six, including sugar, copper, rubber, cotton and corn.

Last month, the CSRC approved the Zhengzhou Commodity Exchange to introduce options contracts on purified terephthalic acid, known as PTA, a raw material for polyester; methanol; and rapeseed meal. It also cleared the DCE to trade iron ore options and the Shanghai Futures Exchange for gold options, expanding China’s commodities options to 11.

In financial options, the CSRC last month gave the green light to the trading of three new stock index options, increasing the number of listed financial derivatives to seven.

A derivative is a contract with a value that is based on fluctuations in the underlying asset, such as stocks, bonds, commodities, currencies, interest rates and market indexes. Common derivatives include futures contracts, forwards, options and swaps. Businesses and investors can use derivatives to lock in prices, hedge against unfavorable movements in the underlying asset and mitigate risks.

“The options market, though a niche market, is an essential part of the capital market,” an executive at a foreign investment bank told Caixin.

Blamed for Market Volatility

With China’s capital markets increasingly opening to the world, foreign investors are more and more interested in investing in the A-share market, but they have broad and diverse demands for managing risk exposure in trading, especially for hedge funds, which now wait on the sideline because of a dearth of hedging tools.

Derivatives are also considered a two-edged sword because their values are vulnerable to market sentiment and can fluctuate sharply. They are usually leveraged instruments where one commits to buy or sell a large number of stocks or volume of commodities by paying only a part of the total cost, which can potentially lead to phenomenal profits and losses.

Excessive leverage and potential leverage-induced sales are considered to be major contributing factors to many past financial crises, including China’s 2015 stock crash, which wiped out a third of the market’s value within a month.

Chinese authorities blamed foreign investors’ shorting of A-shares or the A-share index via offshore derivatives trading for worsening the stock plunge. There were reports that the 2015 stock crash was preceded by high-frequency trading activities betting on the Chinese stock index. Chinese police launched an investigation into so-called “malicious short-selling” in the futures market. Later, the stock exchange imposed a three-month suspension of trading on some securities accounts involved in frequent trading.

During the stock crash, China imposed a series of restrictions on stock index trading. In September 2015, the China Financial Futures Exchange raised margin requirements on futures contracts for investors placing directional bets from 10% to 40% of contract value. For investors engaged in hedging, margin requirements doubled to 20%.

The rules were not relaxed until two years later when regulators determined that China’s stock market had fully recovered. Since then, China has sped up approval of stock and commodities derivatives that were stranded for nearly a decade.

More Rational Understanding

After the 2015 stock crash, the market’s understanding of derivatives has gradually grown more rational and objective, said Yu Li, head of derivatives investment at Chaos Ternary Asset Management Co. Ltd., a Shanghai-based futures trading company. The recent expansion of options offerings will improve risk management tools and diversify investment strategies, thus increasing the willingness of investors to participate in the A-share market, Yu said.

Options are a precision trading tool and can be used for comprehensive risk management, Yu said. Unlike stock index futures, where investors can place only directional bets on the stock market, in options trading, investors can buy or sell call options, which give the holder the right to buy a stock or commodity at a set price on a specific date, and put options, which give the holder the right to sell a stock, commodity or index. Especially in this year’s volatile stock market, options can provide investors more strategies, Yu said.

Many have long considered derivatives only as a hostile short-selling mechanism, but there is no good or evil distinction between long and short transactions, and short-selling using derivatives can correspond with long positions, said Sha Shi, senior adviser at the China Financial Futures Exchange.

In 2015, the Shanghai Stock Exchange introduced its SSE 50 ETF, or exchange traded fund, as China’s first standardized stock index contract. It has since played an important role in promoting liquidity, smoothing price fluctuations, attracting long-term funds and promoting the normalization of stock valuation, Yu said.

Trading in the SSE 50 ETF option hasn’t siphoned money away from the stock market and has attracted more incremental funds to the market, data shows. Traders in the option increased to 400,000 from 30,000 four years ago, Yu said.

Long Way to Go

Through the Qualified Foreign Institutional Investor (QFII) program and the Shanghai-Hong Kong and Shenzhen-Hong Kong stock connect programs, China has been encouraging foreign investors to buy A-shares. Global investors are nonetheless still underweighted on Chinese stocks.

As of the end of June, foreign holdings of A-shares via the stock connect and QFII programs stood at 1.7 trillion yuan ($240 billion), or about 3.2% of total market value. Compared with other developing economies, such as India where foreign investors hold about 20% of domestic stocks and Brazil with about 40% foreign holdings, China has a long way to catch up.

Global investors participating the QFII and stock connect programs are either long-term value investment funds, which usually buy and hold stocks for three to five years and don’t need to hedge their positions, or hedge funds, which usually take the model of holding long positions and hedging with derivatives. For hedge funds, sound risk management tools are necessary.

In January, China broadened the investment scope of foreign investors in the QFII program to derivatives, including financial futures, commodities futures and options, according to draft rules issued by the CSRC.

Since February 2019, the China Financial Futures Exchange has relaxed index futures trading rules four times, including reducing margin requirements, cutting trading fees and allowing more trading activities. Futures trading has increased significantly since the end of 2018.

Contact reporter Denise Jia (huijuanjia@caixin.com)

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