China has finally introduced margin trading, short selling and index futures with a view to creating “multi-tiered” capital markets. Margin trading and short selling came first, limited to pilot projects involving a handful of brokers who are only allowed to trade the top 50 Shanghai-listed firms and the top 40 Shenzhen-listed firms. A couple of weeks later, on April 16, index futures – based on the CSI 300 Index – were rolled out.
It was a landmark event – not that you would have thought so given the initial lackluster response from investors. On the institutional side, they chose to adopt a “wait-and-see” attitude, hanging back until clear patterns emerged. As for retail investors, while they are familiar with the names of these innovative mechanisms from newspaper headlines, few fully understand how the arrangement actually works.
So what is on offer? Index futures are contracts to buy or sell a stock barometer at an agreed value on a preset date. They are often used as hedging tools to cover potential losses.
Put simply, if you have a portfolio of equities and you are concerned that values might plunge in coming months, you take out an index futures contract betting that the stock gauge will plummet. If this happens, then the profit on the futures contract offsets the declining value of the underlying shares. It’s a much cheaper hedging tool than selling the entire portfolio of stocks, given commission fees.
Margin trading allows retail investors to borrow money from brokers to fund stock purchases. Short selling permits investors to sell borrowed equities with the intention of buying them back later at a lower price to make a profit.
There is a big difference between knowing the theory and putting it into practice. It was reported that more than 80% of Chinese investors who participated in mock trading of stock index futures ended up losing money.
Zhu Yuchen, general manager of the China Financial Futures Exchange, where stock index futures are traded, has said the bourse is “purely for professional investors.” Indeed, individual investors must stump up RMB500,000 to open a derivatives-trading account, which put participation well beyond the means of many retail investors.
The new products have the potential to boost liquidity and turnover in the market – if they are properly leveraged and regulated. Let in speculators and suddenly the risk factor rises and volatility becomes likely.
The warning signs are there. The launch of index futures and short selling has already spurred a rally in many blue chips in recent months on speculation these underlying shares would be heavily bought by institutional investors. This is a result of some analysts exaggerating the impact of index futures on heavyweight stocks, whose movement is ultimately based on corporate fundamentals and growth prospect rather than any financial derivative.
Short selling won’t have a big scale on the initial stage as participation is currently restricted to just six domestic securities houses. The restriction means that these brokers will be extremely reluctant to loan their securities so investors can sell short if they brokers themselves also believe the market may drop. Under such a scenario, the brokers would rather sell the securities themselves rather than collect paltry interest payments from lending to investors.
This conflict doesn’t exist in mature capital markets because the role of a securities firm is purely that of broker between borrowers and lenders of securities. It represents a dilemma for the Chinese regulators: On one hand, they want to minimize risk by limiting the volume of derivatives; on the other, they fear these limitations may cripple turnover and spark speculation as so few equities are available for shorting.
As for margin trading, big investors may use it to borrow capital for subscriptions of new shares in initial public offerings. The danger here is that issue prices for popular companies could become bloated, resulting in volatility in first-day trading.
The underlying concern across all these new products is how to protect the interests of minority investors. Derivatives trading is not something they will participate in, but nevertheless it could greatly affect the prices of stocks they hold. These investors must rely on regulatory transparency, which is in turn dependent on timely and accurate public information disclosures of margin trading and short selling on every stock in every trading session.
No investor should be immune to scrutiny. It is especially important that large players like insurers, fund managers and China’s powerful National Social Security Fund also reveal their derivatives dealings on a regular basis to ensure no illegal market-making activities take place.
What is required is a special inspection team, under the securities regulator, that supervises derivatives trading and releases activity reports at least once a week. Without some degree of public oversight to engender public confidence in these new products, they will never attract the mass following that their long-term survival depends on.