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A Futures Market with Chinese Characteristics

By Ted Naganawa

12 January, 2009

2008 was another exciting year for China’s futures industry.  Having grown 87 percent from the previous year, total volume on the three exchanges in Dalian, Shanghai, and Zhengzhou reached 1.36 billion contracts, which translated into more than 5.5 million contracts a trading day.  Although the inflation scare earlier in the year and the ongoing global financial crisis no doubt helped boost trading activity tremendously, the performance of China’s futures industry last year looked particularly salient, given that all three exchanges respectively contributed to the phenomenal growth, with some of the more recently-listed contracts trading well along with their veteran siblings.

However, it was hard to say that everybody did okay in this unusually tumultuous year, and aside from more than a few derivatives-related losses that major corporations suffered, there were also anxieties and confusions lingering over the only contract launched last year, gold futures, as well as long-awaited CSI 300 stock index futures.

The leading exchange in 2008, in terms of growth, was again, the Zhengzhou Commodity Exchange (ZCE), where 445 million contracts traded, up 139 percent from 2007, following 101 percent a year before.  The ZCE’s market share rose from 25.5 percent in 2007 to 32.6 percent in 2008, although larger growth was posted during the first half of the year, and the market share reverted to 25 percent during the month of December.  The Dalian Commodity Exchange (DCE) maintained the status of China’s largest exchange, in terms of total volume, with 638 million contracts, up 72 percent from 2007, and a market share of 47 percent.  The Shanghai Futures Exchange (SHFE)’s market share was 20.6 percent in 2008, but in fairness, that was mainly due to the relatively large size of SHFE’s contracts, and trading activity picked up toward the year-end, raising SHFE’s market share to 37 percent during the month of December.

The impressive growth last year was also achieved through heightened activity in such veteran contracts as copper, aluminum, and soybeans, as well as the rapid growth of their more recently-listed counterparts.  Most notably, ZCE white sugar futures contract was launched on January 6, 2006, but, being only a year old in 2007, it was already the fifth most actively traded agricultural contract in the world, and last year it traded 331 million contracts or more than 1.3 million contracts daily, up 264 percent from 2007, comprising 24 percent of all futures contracts traded in China.  The ZCE also reaped success with another contract, pure terephthalic acid (PTA) futures, which was launched on December 18, 2006 and traded a respectable 35 million contracts last year, up 254 percent from 2007, comprising 2.6 percent of all futures contracts traded.

In addition to PTA, which is used in clothing, China’s futures industry has been showing amazing foresight in introducing the kind of futures contracts that suit the unique nature of China’s economy and the growing demand from Chinese producers and manufacturers.  SHFE Zinc futures contract was listed on March 26, 2007 and last year traded 47 million contracts or 3.5 percent of all futures contracts traded, which was surprisingly more than the veteran copper contract traded last year, 32.7 million or 3.1 percent, respectively.  The DCE launched futures on linear low-density polyethylene (LLDPE), which is used for plastics, on July 9, 2007, and last year it traded 26.5 million contracts, accounting for 1.9 percent of all futures contracts traded.  In another words, it was a combination of market volatility and industry’s creativity that brought about the outstanding growth over the last few years.

Yet, unfortunately, on the back of various negative developments involving futures and derivatives around the world, China’s futures industry could not stay totally hassle-free.  On January 9, 2008, the SHFE launched gold futures contract, the first precious metal futures in China for years.  Although it was received with much fanfare at the beginning, and 121,468 contracts traded on the first day, initial enthusiasm soon died down, and throughout 2008 gold futures traded only 7.8 million contracts, or 32,286 a day, compared with a year older sister, zinc futures’ 191,418 contracts a day.  But the real problem with gold futures was not its anemic performance but the false sense of opportunity it accompanied and the resultant losses that plagued mostly ill-advised individual investors, as well as frauds and investment schemes that helped destroy confidence among especially newer participants in China’s futures market.

Needless to say, the havocs gold futures wreaked last year should have raised the level of concern among regulators and industry leaders and not to a small degree contributed to the decision to put off the launching of CSI 300 index futures, which marked the two-year anniversary of mock trading on the China Financial Futures Exchange (CFFEX) on October 30, 2008, potentially more than the crash of the stock market or the sensitivity surrounding the Beijing Olympic Games did.  Besides the investors’ craving for another market instrument, the real question to answer is if a stock index futures contract is truly needed and what good its introduction will bring to China’s financial market and the overall economy.  As the global financial crisis unmistakably showed, the existence of stock index or any other financial futures does not necessarily prevent irrational exuberance or subsequent crash.  If expected cost appears to outweigh potential benefit, the CFFEX should reconsider the launching of CSI 300 index futures and instead shift its focus to less speculative contracts, such as Treasury bond futures.

In theory, the free market works, and futures and other derivatives markets work, too, but only if every participant understands the market equally and has equal access to information.  While Chinese investors, both retail and institutional, are becoming increasingly sophisticated, it is questionable if they have reached the standard that a truly free market requires, which now it is unsure if even American or any other overseas investors are meeting, given the recent incidents involving US-based hedge funds or Lehman mini-bonds in Hong Kong.  Therefore, ill-conceived launching of CSI 300 index futures will likely hurt another batch of retail investors who are not quite aware of the kind of risk they are assuming and a number of institutional hedgers who think they know what they are doing but actually not.

In that sense, 2008 presented us with some hard-to-learn lessons of large but not-so-catastrophic losses resulting from reckless hedging.  CITIC Pacific tried to hedge foreign exchange exposures but instead lost nearly HK$10 billion by trading Australian dollar forward contracts with 13 domestic and foreign banks.  As the result, the parent company, CITIC Group had to provide US$ 1.5 billion bridge loans to prevent it from going belly-up.  Also, with oil prices precipitating from the summer’s high, Air China lost US$5.9 million on an unrealized basis over fuel hedge, and a few other airlines followed suit with smaller losses.  Then, Chinese container shipping giant, China Ocean Shipping Company (COSCO) has reportedly lost RMB3.95 billion with Forward Freight Agreement contracts on the Baltic Dry Freight Index.  Although institutional hedgers are supposed to have advantage in market intelligence, if the COSCO loses money on freight rates, it is probably not unfair to assume that no one really knows what’s going on.

For 2009 and beyond, what China’s futures industry, which has so far been quite successful building a futures market with Chinese characteristics, needs is, I think, market conscience.  Chinese regulators, the China Securities Regulatory Commission, have already been adequately prudent, but as recent incidents both home and abroad indicated, they cannot be too cautious this day and age, and it’s always better safe than sorry, especially when it comes to the launching of stock index futures.  At the same time, the futures industry overall can be more forthright about the risk involved in futures.

Having associated with many futures professionals and taken the futures industry qualification exam (an equivalent of Series 3) in China, I’m personally confident with the level of knowledge and sophistication among Chinese industry experts.  It is just a matter of becoming a bit bold when facing market participants or customers, advising hedgers to be aware of what they are doing and warning individuals that they are more likely to lose money.  And after experiencing the erosion of confidence through the recent financial crisis, foreign experts should be more willing to learn from the way the futures market is evolving somewhat differently in China from in our home markets, while making substantive contributions, including the development of managed futures or futures funds in China.

About the Authors

Ted Naganawa is a US-China Strategist at TedStrategy.com, president of Ted Naganawa LLC, a US research & consulting company, and a former visiting scholar at Fudan University in Shanghai, China.  Ted is currently starting "China Futures Group" and "US Policy on China & the Rest of the World Group" at LinkedIn.