It may have had a price tag of US$210 million, but the UBS investment into Beijing Securities had more than just monetary significance.
In allowing a foreign firm to take management control of a Chinese brokerage, Beijing publicly accepted what has been common knowledge for a while: foreign expertise is required to turn Chinese brokerages into money makers – and to keep them honest.
Nowhere is this more pertinent than in the world of futures trading, a market that China has expressed a wish to develop and one that lives and dies by its efficiency and the ability to hold all players to account.
Indeed, while UBS has followed Goldman Sachs and Morgan Stanley by going into partnership with a domestic brokerage, ABN AMRO has specifically targeted futures through a proposed joint venture with Beijing-based Galaxy Securities.
"China has the potential to be the biggest futures market in Asia within the next five years," said Steve Ng, ABN AMRO's head of global futures for Asia.
Futures key to reform
Offsetting risk through futures is key to China's ongoing financial sector reforms. The release of state-held non-tradable shares in listed companies should eventually create a surge in the volume of stock traded on China's stock exchanges, and the more money in play, the greater the need for a mechanism that allows traders to hedge against potential downturns.
China's past experiences with financial futures have not been pleasant, though. Launched in 1990, the country's futures markets endured five or so years of inadequate regulation and alleged insider trading among the 1,000 or so brokerage firms operating across 50 exchanges.
Events reached a nadir in 1995 as short-selling strategies on treasury bond futures went disastrously wrong and threatened to bring down the financial system. Beijing responded with a crackdown on futures trading, closing down the trading of most contracts and permitting just 180 brokerages to trade only 12 commodities on three exchanges – in Shanghai, Zhengzhou and Dalian.
As it now stands, futures contracts are available only for such commodities as copper, aluminium, natural rubber, fuel oil, wheat, cotton, corn and soybeans. Further commodity offerings are under consideration but it is the imminent relaunch of financial futures that is drawing most attention.
Financial futures on the way
In September, the Shanghai and Shenzhen stock exchanges set up China Stock Index Limited, a company designed to provide underlying indices for investors in the planned stock index futures products. Futures contracts based on interest rates, treasury bonds and currency have all been touted to follow.
The timescale for the roll-out of these products remains unclear as there are still regulatory and structural issues to be resolved, and the China Securities Regulatory Commission (CSRC) is keeping its cards close to its chest.
"First they have to deal with the brokerages that are in financial trouble and complete the share conversion program, which will see some people receive 'put' or 'call' options," said Ivan Chung, managing director of credit ratings at Xinhua Finance, a company which also markets stock indices for use in stock index futures trading.
Chung said he expects stock index futures to make their mainland market debut over the next 18 months, while equity futures – futures contracts based on the price of individual shares – could take at least two years to arrive. Chung believes the successful launch of equity futures will be a sign that the market has passed its initial tests.
With past misdemeanors still casting a long shadow over the industry – it was only last year that China Aviation Oil (Singapore) lost US$550 million through failed futures bets on the price of oil – the regulators are in no mood to rush things.
Slow start for derivatives
Financial derivatives trading has started slowly with the yuan-denominated currency forwards, a simple, over-the-counter instrument which allows investors to protect themselves against currency fluctuations.
The price and delivery date of the assets being bought or sold under a forward contract are all agreed in advance; investors are not obliged to meet daily margins to cover any losses made on contracts over the preceding 24 hours. A lack of discipline in monitoring margin payments was largely responsible for the problems in the 1990s. The regulators are also making efforts to educate brokers on how to use the markets effectively, often drawing on the expertise of foreign investors.
"We have held seminars on topics such as derivatives in order to raise the level of understanding," said Simon Jin, head of fixed income for UBS in Hong Kong.
In Ivan Chung's view, though, no matter how many training courses these foreign banks run, their presence and activity in the market itself remains the key to success.
"Foreign investment in the market is most important and the overhaul of risk management that comes with it," he said. In exchange for sharing their expertise, the foreign banks not only gain access to a market with great long term potential but also, as one analyst put it, "win a place in the CSRC's good books." A company that helps develop the market can expect to find favor when prosperous times give rise to further investment opportunities.
As to when these prosperous times will kick in, it all comes down to whether China's brokerages have the motivation and the ability to adapt.
"The big question is will the brokers overexpose themselves," said Chung. "No one knows if they can do it because there is no experience to go on."