China took a big step in the development of both its financial and risk management markets when it officially inaugurated, on Sept. 8, the China Financial Futures Exchange in Shanghai. This exchange will extend into the financial sphere an industry that’s already thriving in commodities. Since the 1990s, the Dalian Commodity Exchange, the Shanghai Futures Exchange, and the Zhengzhou Commodity Exchange have been trading a healthy slate of commodity futures, such as copper and fuel oil at the SFE, soybeans and corn at the DCE, and sugar and wheat at the The Dawning ZCE. Volume should top 200 million contracts this of Financial year, an impressive increase from 27 million in 2000. Some 183 firms provide brokerage and Futures In support services. China To be sure, the launch of the new exchange was a bit of an anti-climax, since it was accompanied By Nick Ronalds by no product launch or even an announcement and Wang Xue Qin of a launch date. Still, the official establishment of a financial futures exchange was a clear sign that financial futures will not be long in coming. And though we did not have a launch date as of late October, when this article was written, much about the new exchange is taking shape. 54 Futures Industry Ownership Structure that cannot afford full clearing member- ship. TCMs may not clear for non-clearing The competition among existing futures Exchange rules are still under discussion, brokers. Minimum capital: RMB 50 mil- and securities exchanges for the right to so the information available is somewhat lion. launch financial futures products was fierce. tentative and based on published reports and • Full clearing member: can clear both pro- A stock index contract, to name just the informal documents made available by key prietary and agency business, and in addi- first planned product, is universally CFFEX planners. The following overview tion can clear for non-clearing brokers. expected to be a hit. But in China, neither therefore should be regarded as tentative Minimum capital: RMB 100 million. Only exchanges nor products are launched on an and subject to modification before actual licensed futures brokers may be full clear- entrepreneurial basis. With memories of the trading begins. ing members. chaotic proliferation of exchanges in the The membership structure of the CFFEX • Special clearing member: may clear on an mid-1990’s still fresh, the regulatory author- resembles that of many Western exchanges, agency basis only. This category is ity, the China Securities Regulatory such as Eurex. That is, the various categories restricted to banks, which are prohibited Commission, has kept a tight grip on what of membership are suited to different types of from engaging in proprietary trading. The is listed and where. Hence the stakes were enterprises and have duties and obligations capital requirement will be RMB 200 mil- high for the rights to financial futures. corresponding to their privileges. Foreign lion, twice that of full clearing members, The solution to the ownership question firms cannot become members directly, but it because the banks are expected to do large was Solomonic. Each of the five existing is possible, though difficult, to form joint volumes on behalf of customers. mainland Chinese exchanges—two securi- ventures with local brokerage firms. The • Non-clearing members wishing to trade for ties exchanges, three commodities—gets an rules were developed in a collaborative their own account only need capital of just equal share in the new financial futures process involving the exchanges, the CSRC, RMB 10 million. For both proprietary and exchange. The Shanghai Stock Exchange, member firms, and the major financial mar- agency business, the requirement is RMB the Shenzhen Stock Exchange, the ket players expected to be active partici- 30 million. Shanghai Futures Exchange, the Dalian pants, such as banks and securities firms. The Several of the categories above refer to Commodity Exchange, and the Zhengzhou membership categories are: proprietary trading on the part of futures Commodity Exchange each get a 20% • Trading clearing member: can clear its own commission merchants. At present propri- equity stake in the CFFEX. The registered proprietary trades as well as trades done on etary trading by FCMs is strictly prohibited. capital of the CFFEX is RMB 500 million an agency basis. This category will be the The memberships are structured on the (about $62.5 million at $1 = RMB 8). choice of futures commission merchants The CSRC has named Zhu Yuchen, for- merly head of the Dalian Exchange, as gen- eral manager, a position equivalent to president at U.S. exchanges. Zhu spent a Another Player in the Wings? nine-month internship at the Chicago exchanges in 1990, when he was a mid- Another player may yet make an entrance in the exchange-traded derivatives level official of China’s Ministry of space. The China Foreign Exchange Trading System, an affiliate of the central Commerce. Shortly after returning to bank, has concluded a memorandum of understanding with the Chicago China he left the ministry and became a Mercantile Exchange to become a “super-clearer” of CME products. CFETS senior manager of Cifco, one of China’s first serves as a clearinghouse for all cash foreign exchange transactions in China. futures brokers and still one of the largest. A There have been hints it has ambitions to become a futures exchange for foreign chairman had not been selected as of end- exchange, and perhaps other products, in its own right. Political obstacles make October. this prospect uncertain at this stage, however.—Nick Ronalds and Wang Xue Qin November/December 2006 55 assumption that this prohibition will be • Have qualified personnel at all levels access. In return they guarantee their cus- lifted. When this might happen is uncertain; • Meet other conditions that the CSRC tomers and, beyond that, the integrity of the a change in the relevant law has to come first, and/or the exchange might require. exchange in the event of default of another and it is likely that this will not happen until The hurdles, particularly the financial clearing member. sometime after the launch of the contract. ones, are quite high by Chinese standards. The CFFEX has adopted a tiered default Table 1 summarizes the capital require- And clearly, they leave considerable room payment model recognizable to those famil- ments and other fees for these categories of for subjective judgment by the exchange and iar with Western exchanges. As the first line membership. In addition to the indicated its regulators. This rigor flows from a deter- of defense, a clearing member is responsible capital requirements, all members must meet mination to avoid any repeats of the abuse- for all obligations of its customers. If a cus- the following rather stringent operational prone environment of the 1990s. The tomer’s default causes the default of the and management criteria: membership requirements allow the clearing member, a “common bond” kicks in: • Be a registered legal entity with all required exchanges and regulators to limit participa- all clearing members contribute to making business licenses. tion in the new market to firms deemed good on the deficit. The contribution will be • Be of good reputation with a strong man- responsible and qualified, and with enough based on a formula, probably related to a agement history on the line to make rule violations a risky clearing member’s size as measured by histor- • Have committed no serious legal violations proposition. ical volume and/or open interest. in the prior five years. When that limit is reached, the • Have a management structure in place Member Firm Obligations exchange’s “Risk Fund,” which will build suited to the business and its membership An essential aim of the membership with time based on a transaction fee, category. structure of a futures exchange is to promote becomes the last line of defense. Exchange or • Be able to demonstrate a strong system of financial integrity. Members have certain clearing fees have not been officially internal risk control, including real-time privileges, such as the exclusive right to clear announced, but knowledgeable observers risk management and IT systems. trades and perhaps advantageous market indicate the fee will be one-tenth the value of the multiplier. For example, if the multi- plier is 300, the fee would be RMB 30, i.e., Table 1 (about $3.75). Of that, 20% will go toward the Risk Fund. CFFEX Membership Structure When proprietary trading by FCMs is allowed, customer funds will be segregated Important note: the criteria in this table have not been finalized but commingled, as is the case in the U.S. In and may change before the official launch. other words, the customer funds will be seg- regated from the FCMs’ own funds, but the Clearing Member Non-Clearing Member customer funds will not be segregated Trading account by account. Instead they will be in Special Agent & Only Membership (proprietary) one consolidated account at the exchange Full clearing proprietary proprietary Category clearing (for required margins) and/or at a bank (for member business business member excess margin). 50 100 200 30 10 Products Minimum million yuan million yuan million yuan million yuan million yuan Registered The first product will be a stock index (US$6.25 (US$12.5 (US$25 (US$3.75 (US$1.25 Capital contract. Based on their desire for an under- million) million) million) million) million) lying instrument that was both representa- tive of the total market and resistant to Initial Clearing 10 20 50 manipulation, the exchange’s planners and Guarantee million yuan million yuan million yuan — — regulators selected the Shanghai-Shenzhen Capital 300, or “Hushen” 300 index. This index, which was created in April 2005 in the Minimum expectation that it would become the basis Balance of 2 million 2 million 2 million — — for a futures contract, is a capitalization- Clearing yuan yuan yuan weighted index of 300 representative A- Reserve share stocks.