On January 8, the State Council granted the China Securities Regulatory Commission (CSRC) approval "in principle" to introduce stock index futures. If the lessons of China’s past financial reforms are any indication, however, traders in Shanghai may still have a long wait ahead.
The China Financial Futures Exchange was created in Shanghai in 2006 to help launch derivatives. The financial reforms that would have enabled derivatives were approved two years ago, with calls for their introduction extending as far back as 2000. In late 2008, the regulator once again promised to introduce innovations like margin trading and short selling; it was a small public relations coup, a vote of confidence in China after the collapse of global markets, but nothing came of it.
Now, the CSRC has claimed that preparations and trials for the futures exchange will require three months, but even that deadline seems preciously optimistic.
Introducing a futures market is certainly a step forward. After all, China’s one-sided stock market means that investors can only profit from stock price increases. Without a choice of investment alternatives, money chases money into equities – and, when things turn sour, money chases money back out again. It is a recipe for volatility. Yes, the Shanghai Composite Index gained a massive 80% in 2009. But the year before that it was the worst performing major index in the world; and the year before that it was the best performing; and so the cycle goes on.
Futures trading, short selling and margin trading – all recently approved or granted trial programs by the State Council – are important hedging tools that will assist in more accurate price discovery. At the same time, China’s regulators are potentially opening Pandora’s box as they offer newer, riskier investment vehicles to local investors.
China cannot be blind to the lessons of Barings Bank, where a single rogue trader brought down a respected financial institution, or, closer to home, Shanghai International Securities and the bond futures scandal of the mid-1990s.
Regulators are also aware that the recent global financial crisis was spawned in part due to the intricate complications of derivatives and the accompanying "shadow banking" system. Stock index futures, margin trading and short selling are hardly complex and untried investment tools, but for the CSRC such innovations are the undiscovered country. Even if they are introduced, their scope will be limited.
The CSRC is already introducing measures to restrict entry to the index futures market. Investors must pass an exam in order to participate in trading, and individual futures trading accounts require a minimum capital of RMB500,000 (US$73,200). Futures contracts will each cost RMB105,000 (US$15,380), setting an additional cost barrier to keep out inexperienced retail investors. Investors will also have to purchase 10% of the value of the futures contract as collateral.
Furthermore, initial results from Chinese futures trading simulations conducted since 2007 indicate biases toward long positions (bets that stock prices will go up) and decreasing volatility over time. Both are good news.
The government’s goal of turning Shanghai into a financial hub by 2020 to compete with more mature markets is a process that requires extensive financial reforms and regulation. Adding depth to the market through the introduction of new financial vehicles – even if these do open new roads along which the capricious animal spirits of China’s investors may roam – should therefore be welcomed.
Knowing the typical process of financial regulation in China, however, investors might want to hold off on the celebrations for now.