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 , member firms, and the major financial mar- agency business, the requirement is RMB the 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 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 , is a capitalization- Clearing yuan yuan yuan weighted index of 300 representative A- Reserve share stocks. Under China’s two-tier system, Qualification 0.02 million 0.02 million “A” shares are tradable only by residents, Fee — — — yuan yuan

56 Futures Industry while identical “B” shares, smaller in num- under the CSRC’s “qualified foreign institu- A revision in the securities laws late last ber, are tradable only by foreigners. tional investor” rules. QFIIs will not be year lifted the prohibition on stock lending. The market capitalization of the index as allowed to trade the index futures, but the However, neither stock lending nor short sell- of mid-October was about RMB 3.5 trillion adoption of a similar approach for financial ing will be possible until the CSRC issues and embraced some 67% of the total com- futures is likely in the future. detailed regulations on the subject. When this bined market capitalization of the Shanghai Table 2 shows key contract specifica- will happen is unclear at present, but it is vir- and Shenzhen exchanges, considerably more tions. The multiplier is 300. Smaller multi- tually certain that short selling in the cash than the other Chinese indexes in wide use. pliers were considered, but what won the day market will not be possible by the time the Its correlation to the total market is 0.978, was a desire to keep the contract big enough contract is launched. The inability to sell cash higher than all the other widely used indexes for hedgers and too big for the potentially equities short will have the effect of inhibiting with the exception of the S&P 300, which vulnerable small speculators. Based on an arbitrage when futures are at a discount from had the same correlation over the past year. index of 1450, the approximate level at end- fair value. An indication of what to expect is The value of trading over the past year was October, a multiplier of 300 would imply a provided by India, where short selling is also over RMB 2.2 trillion, and average daily value of RMB 1450 x 300 = 435,000 RMB, prohibited and the Indian stock index futures turnover was 1.29%. (The statistics on market or $54,375 (at $1 = 8 RMB). contracts, the S&P CNX Nifty, indeed fre- capitalization and correlation are from a pres- The maximum daily limit move will be quently trades at a discount. Simulated trad- entation by Li Hongyang, Shenzhen Financial 10%. If the market moves 6% up or down ing for the Hushen started on November 6. Engineering School, Nankai University, at from the previous day’s close, however, a 10 Participants include over 80 institutional the FOW 13th Derivatives & Securities minute trading suspension goes into effect. investors, most FCMs, and over 3,000 indi- World conference in Singapore on Oct. 4.) Thereafter trading resumes and the 10% viduls. Even some reporters will be in the fray, Currently a small number of foreign limit move is in effect. practicing participatory journalism. investors are permitted to trade the A shares Other Products The Hushen contract will be first off the Table 2 block, and clearly it is the focus of all the attention for now. But additional contracts Hushen 300 Stock Index Futures for the new exchange have already been dis- cussed. Jiang Yang, the assistant to the Contract Specifications CSRC Chairman and former President of Important note: the criteria in this table have not been finalized the Shanghai Futures Exchange, was quoted and may change before the official launch. in a Sept. 11 report in China Futures Market Weekly that after the stock index contract, Underlying Shanghai Shenzhen 300 Index there will follow “a slew of other financial futures and options.” A bond contract leads Multiplier 300 Yuan (RMB) the pack, and foreign currency futures are under discussion. Quoted Price Index points Minimum Tick 0.1 points Foreign Participation Non-residents cannot trade Chinese Contract months Two serial months and nearest two quarterlies futures. Chinese firms owned or partially owned by foreign capital would be legally Daily Price Limit 10% Chinese and hence could do so. Eventually Margin Minimum: 8% of contract value laws will be relaxed to admit foreign traders, but this will likely happen gradu- Trading hours 9:15 - 11:30 a.m.; 1:00 - 3:15 p.m. ally, on the QFII model of the equity mar- kets. A QFII is a well capitalized, reputable Based on weighted average of trades during the last hour of trading institution granted an investment quota Daily Settlement except on last trading day, when it will be a weighted average of the last that it in turn allocates among customers. two hours’ trades. The QFII approach allows Chinese regula- Last Trading Day Third Friday of expiration month tors to open the market gradually while exerting quality control. Initiation of such Value of the index at the close of trading of the cash index on the last market opening measures are unlikely Final Settlement Price trading day before the end of next year.

58 Futures Industry Foreign firms are already permitted to buy the industry as a whole. The possibility of if SOEs conducted hedge trading at the up to 49% equity stakes in Chinese FCMs exchange mergers to usher in a combination exchange.” Most local observers caution that and thereby participate in the Chinese of such benefits in one fell swoop is being dis- initial volume will be modest, but the under- futures market as brokers. To date, Dutch- cussed as well. lying feeling is that the eventual proportions based ABN Amro Bank is the only institu- of the Chinese stock index futures contract tion that has taken this route. Launch will be anything but. ■ Early plans called for a launch of the Challenge to Commodities? index futures contract before the end of The prospect of competition from a new 2006, but organizational and operational Nick Ronalds, CFA, is a director, exchange financial futures exchange has aroused anxi- delays may push the launch into early 2007. traded derivatives in the Chicago office of UBS ety among the established commodity But the buzz is building, and skeptics are Securities. He has visited China frequently. Wang exchanges, which fear cannibalization of non-existent. Recognition of the important Xue Qin is vice-general economist of the speculative volume. But others in the com- role of risk management is spreading. Zhengzhou Commodity Exchange. In 2001 he modity sector see the new products as a wel- Regulators have hinted at liberalization to worked at the Chicago Board Options Exchange come stimulus that could help spur a range of allow even state-owned enterprises to hedge. as a visiting scholar and studied options theory innovations and enhancements. Possibilities A vice minister of the State-Owned Assets and trading strategy at the Illinois Institute of include enhancements in margining systems Supervision and Administration Commis- Technology. He has published over 60 articles on such as netting of positions and cross margin- sion recently was quoted as saying, in a arti- futures-related topics. ing, exchange linkages, more efficient front- cle reprinted on the Chinese government’s end systems, and better customer service for official web portal, “It wouldn’t be a problem

November/December 2006 59 Asian Tigers

The chart below shows the short-term and long-term rate of growth for the 10 largest derivatives exchanges in the Asia-Pacific region, as well as their relative size. Growth is measured in number of futures and options contracts traded at each exchange compared to the same period one year ago and four years ago. Bubble size represents the relative size of each exchange’s volume. All data as of Sept. 30, 2006. Exchanges: DCE = Dalian Commodity Exchange HKEX = Kong Derivatives Exchange KRX = NSE = National Stock Exchange of India OSE = Osaka Securities Exchange SFE = Sydney Futures Exchange SGX - SHFE = Shanghai Futures Exchange Taifex = Futures Exchange Tocom = The Tokyo Commodity Exchange

Note: The Multi-Commodity Exchange of India, one of the top 10 Asian exchanges by volume as of Sept. 30 2006, was excluded from the chart because statistics on the number of contracts traded were not available for the entire four-year period. Volume Growth at Asian Exchanges Exchange Jan-Sep 2006 Jan-Sep 2005 Jan-Sep 2002 % change 12 Months % change 4 years Korea Exchange 1,959.39 1,897.55 1,296.50 3.3% 51.1% National Stock Exchange of India 145.37 87.24 8.39 66.6% 1633.2% 89.72 64.76 5.08 38.5% 1667.1% Dalian Commodity Exchange 82.58 70.35 34.12 17.4% 142.1% Sydney Futures Exchange 59.20 47.77 27.66 23.9% 114.0% The Tokyo Commodity Exchange 51.82 42.19 56.30 22.8% -8.0% Osaka Securities Exchange 44.53 27.90 14.76 59.6% 201.7% Shanghai Futures Exchange 42.57 24.23 7.24 75.7% 488.3% of India 32.33 12.86 N/A 151.4% N/A Hong Kong Derivatives Exchange 30.05 18.47 8.19 62.6% 266.9% Singapore Exchange 28.13 18.09 25.51 55.4% 10.3% Zhengzhou Commodity Exchange 28.09 21.61 N/A 30.0% N/A Tokyo Financial Exchange 25.75 7.45 3.57 245.6% 621.0% 22.53 16.77 11.36 34.4% 98.3% Australian Stock Exchange 16.94 18.17 N/A -6.8% N/A Tokyo Grain Exchange 14.19 20.19 13.87 -29.7% 2.3% Central Japan Commodities Exchange 7.20 18.26 22.41 -60.6% -67.9% Derivatives Berhad 2.81 1.88 0.89 49.9% 216.9% New Zealand Futures Exchange 1.44 0.67 0.54 116.5% 169.5% Osaka Mercantile Exchange 0.51 1.33 4.03 -61.7% -87.3% Kansai Commodities Exchange 0.14 0.85 3.08 -83.3% -95.4% Fukuoka Futures Exchange 0.13 0.79 2.45 -83.0% -94.5% Yokohama Commodity Exchange 0.01 0.35 1.03 -97.0% -99.0% Total Asia Volume 2,685.43 2,419.72 1,546.95 11.0% 73.6%

Total Global Volume 8,954.06 7,295.46 4,483.17 22.7% 99.7% Asian % of Global Volume 30.0% 33.2% 34.5%

Note: The table includes only those exchanges for which the FIA has data. The following exchanges in the Asia-Pacific region do not provide volume to the FIA: Dubai Gold and Commodities Exchange, National Commodity and Derivatives Exchange (India), National Multi-Commodity Exchange (India), and the Singapore Commodity Exchange.

60 Futures Industry