Lecture #24 DERRIVATIVE MARKET IN CHINA

• China has made tremendous steps of reforms and a progressive opening of its markets. China’s financial system has made great progress and has converged on international best practice. As an important part of the modern financial system, financial derivatives have been the focus of much attention in China. A number of RMB derivative types are in use, and the Renminbi (RMB) derivatives market has already reached a mature stage in China.

• Analyzes different derivative products that are being used by Chinese derivative market and also includes the analysis of some research papers that are related to Chinese derivative market. The last part of this presentation includes conclusion and recommendations about the derivative usage in Chinese financial market.

Value-At-Risk

• China's financial system is highly regulated and has recently begun to expand rapidly as monetary policy becomes integral to its overall economic policy. As a result, banks are becoming more important to China's economy by providing increasingly morefinance to enterprises for investment, seeking deposits from the public to mop up excess liquidity, and lending money to the government.

Financial market of china

• As part of US$586 billion economic stimulus package of November 2008, the government is planning to remove loan quotas and ceilings for all lenders, and increase bank credit for priority projects, including rural areas, small businesses, technology companies, iron and cement companies.

• There are stock exchanges in Shanghai (the third largest in the world), and Shenzhen and futures exchanges in Shanghai, Dalian, and Zhengzhou. They are regulated by the China Securities Regulatory Commission.

• Stock market• In 1990 and 1991, China set up stock exchanges in

Shanghai and Shenzhen. In the past decade, the Chinese stock market has completed a journey that took many countries over a century to cover; China's stock market today has capital approaching 3,705.6 billion yuan, 1,377 listed companies and 72.16 million investors.

• The Chinese stock market has promoted the reform of government-owned corporations and the change of their systems, and enabled a stable transition between the two systems. On the strength of the stock market in the past decade, many large state-owned enterprises have realized system change.

• The change also has stimulated medium and small-sized state-owned enterprises to adopt the shareholding system, thus solving the most important issue - the system problem - during the transition from planned to a market economy. As for ordinary citizens, bank deposit is not the only way to put their money, the stock market has become one of the most important channels for investment.

• Methods of stock trading are constantly being improved. Today, a network system for securities exchange and account settlement has been formed, with the Shanghai and Shenzhen exchanges as the powerhouse, radiating to all parts of the country. In 2004, China issued 123 kinds of A share, and 23 rights issues, collecting a total of 83.6 billion Yuan; and 28 kinds of B and H shares, collecting a total of 67.5 billion Yuan.

• Development• As China's economy becomes more integrated with the

rest of the world its financial system will become more in line with international practices.China has also learnt from Hong Kong's financial system, with the help of the Hong Kong Monetary Authority.

• Derivative market• China’s derivatives market is developing rapidly and it has great

potential in the eyes of most experts. As the Chinese government have announced, the new administrative rules that have been issued at the end of last year will boost the development of the derivatives trading among banks and financial institutions, which has been proved by the prosperity of CSI300 Index Futures.

• Global Derivatives China 2011 on 11th May 2011 on the Financial Street of Beijing, China will bring together 250+ decision makers from banks , securities , asset management , futures and IT solution providers to discuss the future of China’s derivatives market and such derivatives based products as CSI300 Index Futures.

• Benefits of derivative market• There are number of benefits which the china receives

from the derivative market. Those are:• The development of derivative market causes the

growth in the economy of china.• With the development of derivative market china has

achieved the success globally, thus there was increase in foreign direct investment after the development of derivative market. In this way it reduces the risk for the foreign investors.

• It is effective for china international trade growth.

• There are proper regulatory systems that regulate the OTC derivative market in china as NAFMII (National Association of Financial Market Institutional).

• Commodity futures are more used in china, so, derivative helps for the price discovery of commodities through the continuous flow of information.

• Mostly the derivatives are used for hedging and speculation in china, it helps the hedgers to reduce their risk and speculators to take their position by moving in the market.

• According to fortune 500, 94% of companies started using derivative to manage their financial and business risk.

• China has won the title of world’s largest commodity derivative market in 2010.

• Its GDP reached to 17 trillion in the mid of 2010 which is more than the USA 2.5 trillion.

• Derivatives market development in China• Initial stage• In 1980s, the futures market of the late country with

relevant departments to study abroad, and actively preparing for China's futures market. October 12, 1990 approved by the State Council, China Zhengzhou Grain Wholesale Market introduction of futures trading mechanisms based spot trading, marking the formal establishment of a commodity futures market. The lack of unified management, established around 1993, futures trading over 50. Because of the lack of adequate understanding of the futures market, as well as regulatory lag varieties repeated, illegal trading, market manipulation and other issues, China's futures market in disarray.

• Regulation stage• The State Council in 1993 on the futures market

twice rectification from more than 50 transactions after the rectification reduced to three, respectively, the Shanghai Futures Exchange, Dalian Commodity Exchange and the Zhengzhou Commodity Exchange, the abolition of foreign exchange futures stock warrants, bond futures and index futures, futures varieties from 35 down to 12. Handling violations, standardize market operations to clean up the futures brokerage firm, strengthen supervision and improve the regulations

• Development stage• December 29, 2000, the China Futures Association was

established, marking the Chinese futures market, industry self-regulatory organization to establish. March 2001 steadily develop the futures market "write" the Tenth Five-Year Plan "signs to straighten out the end of China's futures market. Since then, a series of regulations have been put forward to regulate the futures market. In 2002, the China Securities Regulatory Commission issued a new "futures practitioners management approach", "futures brokerage firm senior management qualifications management approach Futures Exchange Management Measures", "futures brokerage firm management approach for the development of the futures market has laid foundation.

• In January 2004, the State Council promulgated the "State Council on promoting the reform and opening up of the capital markets and stable development of a number of opinions" systematic plan for the development of China's futures market. In February 2007, the State Council amended the relevant provisions of the Exchange Management Regulations "to further improve the futures trading. Enter the specification stage of development as the futures market, futures trading volume and transaction volume growing steadily onto the market, some of the new varieties of futures.

• Development• As China's economy becomes more integrated with the rest of the

world its financial system will become more in line with international practices.China has also learnt from Hong Kong's financial system, with the help of the Hong Kong Monetary Authority.

Users• Foreign banks (Australia and New Zealand banking

group, ANZ. JPMorgan chase. BNY Mellon. Heng seng bank etc.)

• Trust and investment companies (Chinese trade and investment in Africa, and HANA UBS Korea China Securities Investment Trust)

• Usage of commodity, equity and credit derivatives is more concentrated among specific industries. While multinational companies across all industries use derivatives to manage foreign exchange and interest rate risk, the use of commodity derivatives is more limited, being concentrated among utilities (83 percent), companies involved in basic materials (79 percent) and financial services companies (63 percent).

• Financial leasing companies and auto financing companies

The renminbi (RMB) is the official currency of China (People's Republic of China). Renminbi is legal tender in mainland China, but not in Hong Kong, Taiwan, or Macau. Renminbi is sometimes accepted in Hong Kong and Macau, and are easily exchanged in the two territories. Banks in Hong Kong allow people to maintain accounts in RMB. It is issued by the People's Bank of China, the monetary authority of China. Its name literally means "people's currency".

Instruments used in derivative market China has made tremendous strides after three decades of reforms

and a progressive opening of its markets. By mid-2010, the country’s GDP reached CNY 17 trillion, more than USD 2.5 trillion, and its high economic growth rate has made a significant contribution to the global economy. GDP per capita, however, is still low. GDP and GDP per capita 1952–2009, CNY billions. Finance is the core of a modern economy. China’s financial system has made great progress, in line with rapid economic growth, and has converged on international best practice. As an important part of the modern financial system, financial derivatives have been the focus of much attention in China. A number of RMB derivative types are in use, and the RMB derivatives market has already reached a mature stage in China.

• Commodity-based financial derivatives:• Commodity futures are the oldest form of derivative. The first

commodities futures market in China, the China Zhengzhou Grain Wholesale Market, opened on 12 October 1990. Subsequently, the Shanghai Futures Exchange and Dalian Commodity Exchange have also started operations.

• Exchange rate derivatives:• Because of China’s growing contribution to the global economy,

the RMB exchange rate has attracted an increasing amount of attention worldwide. Meanwhile, demand for derivatives, especially those related to risk management, has increased steadily from financial institutions and even from non-financial companies and individual investors.

• RMB forwards• In 1994, the China Foreign Exchange Trade System introduced a

spot foreign exchange trading system for financial institutions. Preparatory studies for RMB forward transactions started one year later and, in January 1997, the People’s Bank of China (PBC) formally established its “Interim Management Rules for RMB Forward Exchange Settlement and Sales” as a framework for the development of this business started up its RMB forward exchange settlement and sales business, as the first bank authorized to do so, marking an important milestone in the development of the Chinese derivatives market.

• RMB foreign exchange swaps• RMB exchange swap transactions were introduced in April 2006.

The National Import and Export Bank of China and the Bank of China were the first to execute a deal in the nascent Chinese interbank foreign exchange market.

• RMB futures• In August 2006, the Chicago Mercantile Exchange (CME) launched

futures and option contracts on the CNY against the US dollar, euro and Japanese yen. This brought into being the first RMB derivative market outside China.

• RMB non-deliverable forwards and options• The two most commonly used OTC and off-shore exchange rate

derivatives are non-deliverable forwards (NDF) and options (NDO). • Interest rate derivatives:• RMB interest rate derivatives can help financial institutions to

smooth out fluctuations in these key economic indicators. • RMB bond futures• A pilot scheme for government bond futures was introduced in

December 1992 but was later suspended. Futures trading were restarted in June 2005 in the interbank lending market.

• RMB interest rate swaps• In February 2006, the PBC announced a pilot scheme for RMB

interest rate swap transactions, which greatly promoted the development of this instrument in China.

• RMB exchange rate swaps• In August 2007, the PBC announced guidelines for foreign

exchange swaps, which opened the way for the Chinese Yuan to be swapped against the US dollar, the euro, the Japanese yen, the Hong Kong dollar and sterling in the Chinese interbank foreign exchange market. Such exchange rate swaps are widely used in the interbank market.

• RMB forward rate agreements• In October 2007, the PBC further authorized SHIBOR-based RMB

forward rate agreements. • Equity derivatives:• In February 2010, the China Securities Regulatory Commission

officially approved the HuShen300 stock index futures contracts and business rules on the China Financial Futures Exchange, and HuShen300 stock index futures contracts were first traded on 16 April.

• SHIBOR (Shanghai Interbank Offered Rate)

• China’s market is developing day by day; with this development it has a need for the development of derivative market. Number of instruments can be used in the derivative market as forward, futures, swaps, and options. These four are mature instruments of derivative market. China needs of derivative market for the success of its financial market as well as to reduce the risks for hedger. Through derivatives the hedger can reduce the risk and the financial market that work as speculator (risk taker) provide them the high profit. Globalization has the necessity of derivative instrument. The monetary policy works effectively if the country has the abundant of financial instruments.

• For the improvement of foreign direct investment China should have the derivative market to reduce the risk of foreign investors. It is effective for china international trade growth. Thus, china has the need for the derivative market not only for the international development as well as for the growth of its economy

• Weather derivatives as a new class of financial instruments are used to manage the economic impact of weather conditions on industries like energy, agriculture, insurance, retail, recreation industries etc. The risk in this situation refers to weather events that have high probability of occurrence and not very large payoffs. In 1997, the first transaction was traded on over the counter (OTC) market between Koch industries and Enron on a Heating Degree Days (HDD) Index. Since then the market has developed rapidly.

• The underlying variable behind weather derivatives can be temperature, precipitation, sunshine, wind speed, humidity and storm activity. China is a large agriculture producing country as well its weather changes radically and agriculture industry is greatly affected by weather. So, Chinese companies have realized that weather derivatives provide new opportunities in dealing with weather risks. So, Chinese derivative market has launched weather derivatives for hedging purpose.

• The evolution of financial market in china was started in 1990 as shanghai stock exchange, till the 2010 it now has the separate exchanges for the futures and forwards as well. In June 2005 china’s OTC derivative market has been established and forward bond trading was started. OTC Derivatives Market Participants are national banks, local banks, foreign banks, mutual funds, insurers and other non-financial institutions. There are proper regulatory systems that regulate the OTC derivative market in china as NAFMII (National Association of Financial Market Institutional).

• Interest rate swaps was initiated in 2006 in china. Futures are to be traded on exchanges of china and its participants are qualified individual investors, non-financial legal persons and financial legal persons, others can be the insurance companies and Chinese security funds. For speculation future market index are widely used rather than to OTC instruments.

• China has done a tremendous development in last three decades. Its GDP reached to 17 trillion in the mid of 2010 which is more than the USA. This success is because of use of number of RMB derivative contracts. Commodity futures are the oldest form of derivatives used in china. Now the RMB exchange rate is also used very frequently in china. It is more used in china than to USA.

• The other type of contracts is RMB futures, RMB forward and RMB swaps use in exchange rate derivatives. The other types are interest rate derivatives (RMB bond futures, RMB exchange rate swaps and RMB interest rate swaps) and equity derivatives. These are widely used by the commercial banks, hedgers and arbitrages as well as small businesses. Financial derivatives have been widely used in China in line with the reforms and economic growth of recent years.

• China has won the title of world’s largest commodity derivative market in 2010. Regulators impose more regulations on the derivative market which result the 50% decrease in trading volume in the 1st quarter of 2011. 1990 derivative market was introduced in china, within few years 38 exchanges were established and trade the derivatives. In 1998 the restructuring was done by the regulators of derivative market that reduce the number of exchange from 38 to 3, again this number was increased in 2011.

• The corporations, retail investors and speculators/arbitrages are the participants of derivatives. Exchange increases the commission of brokers to decrease the trading volume while Brokers low their commission to increase the trading volume. The regulation also introduce the number of services that will provide to the investors by the future brokers like risk management, consultation and hedging solution etc., work as CTA (commodity trading advisors) in china. The regulator’s caution approach works best for the development of commodity future market.

• The corporations, retail investors and speculators/arbitrages are the participants of derivatives. Exchange increases the commission of brokers to decrease the trading volume while Brokers low their commission to increase the trading volume. The regulation also introduce the number of services that will provide to the investors by the future brokers like risk management, consultation and hedging solution etc., work as CTA (commodity trading advisors) in china. The regulator’s caution approach works best for the development of commodity future market.

• As an important part of the modern financial system, financial derivatives have been the focus of much attention in China. A number of RMB derivative types are in use, and the RMB derivatives market has already reached a mature stage in China. The first commodities futures market in China opened on 12 October 1990. Subsequently, the Shanghai Futures Exchange and Dalian Commodity Exchange have also started operations. In April 1997, the Bank of China started up its RMB forward exchange settlement and sales business, as the first bank authorized to do so, marking an important milestone in the development of the Chinese derivatives market. RMB exchange swap transactions were introduced in April 2006.

• In February 2006, the people’s bank of China (PBC) announced a pilot scheme for RMB interest rate swap transactions, which greatly promoted the development of this instrument in China. In August 2007, the PBC announced guidelines for foreign exchange swaps, which opened the way for the Chinese yuan to be swapped against the US dollar, the euro, the Japanese yen, the Hong Kong dollar and sterling in the Chinese interbank foreign exchange market. In February 2010, the China Securities Regulatory Commission officially approved the HuShen300 stock index futures contracts and business rules on the China Financial Futures Exchange, and HuShen300 stock index futures contracts were first traded on 16 April.

• The derivative markets play the vital role in the economic growth of any country. The development of derivative market in china was late. In 2007 derivative was on its highest level. China has developed the 1st derivative market in 1990 with name of China Zhengzhou Grain future market. Because of lack of regulations there was illegal trading of futures. 1993 the state council in china has introduced the regulatory bodies for derivative market. The trading on OTC derivative market is more than exchange of futures. Forward and futures are more used then the swaps, no options are to be used in china till now.

• The china’s derivative market has the problems of base product markets are underdeveloped, few varieties of derivatives trading, the lack of pricing power, derivatives market regulatory system is imperfect and Derivatives market to the lack of senior talent. The regulatory bodies/exchanges of derivative market should have to Speed up the development of basic products market, Improve derivatives market supervision system, train senior talents and actively develop derivative products. Derivative market is the cause of economic development in the country. Thus, china has mastered in pricing power and improve the construction of a modern market system in China, enhancing economic security, to ensure sound and rapid economic development.

• According to Hsiao (2012) the enactment of a comprehensive regulation of derivatives in China is a necessity since its economy has transferred from central planning towards a market economy. However, the market is still far from adequate to support such trading. There are serious risks associated with the current derivative regulation transmitted by the Chinese authorities. It is unclear whether the current legal risk of re-characterization is sufficient to ensure effective results of regulatory objective.

• Netting, close out and settlement reforms need to be taken to eliminate market uncertainties. However, all of these problems bring difficult choices and decisions. They will unavoidably involve an intense power struggle and require in-depth reforms in many respects. The regulation on derivatives must be in line with its aim to hedge risk. The missing supporting mechanism and legal uncertainties may lead the market in a different direction. Permission with such trading is a catch 22 (a rule that creates disadvantageous situation).

• According to another study by Chin (2013) Rapid pace of growth of the Chinese economy and the accumulation of wealth will continue to drive the Chinese market for structured products forward. During the past years, commercial banks and other financial institutions, such as fund companies, securities companies and insurance companies have continued to dominate the market for derivatives and structured products in China.Since 2004 according to China Banking Regulatory Commission (CBRC) the derivative and structured product market has undergone a period of rapid growth.

• The CBRC has put in place mechanisms to ensure the healthy growth of the market, including a consultation mechanism for banks and comprehensive risk management rules.In October 2007, National Association of Financial Market Institutional Investors (NAFMII) published a China Inter-bank Market Financial Derivatives Master Agreement, which is intended to govern all financial derivative transactions between inter-bank market members.

• It is widely known that the Chinese futures exchanges have also been guided to rein in speculation and ensure stable prices. In 2010, the commodity exchanges remain in the top 15 global futures and options exchanges based on transacted volume. The exchanges, which are strictly monitored and controlled by the China Securities Regulatory Commission, need not be too concerned about volumes so much as fulfilling an important role in providing a tool for companies to manage price risk. China has mapped out a road map for Shanghai to become a major international financial center by 2020. At the beginning of 2011, the Shanghai Securities News reported that China’s stock market capitalization had overtaken Japan as the world’s second biggest. [Dean (2013)]

• Conclusion• Chinese stock market was established in 1990s and it

caused a rapid growth in Chinese businesses. In 1993 Chinese derivative market was established and led chinese market to number of benefits like growth in china’s GDP, increase in foreign direct investment and overall economic growth. Commodity derivatives are most commonly used in china thus its market has been awarded by title of world’s no. 1 commodity derivative market. derivatives are most commonly used for hedging and speculation in china

• Financial derivatives have been widely used in China in line with the reforms and economic growth of recent years, but much work remains to be done in the areas of how derivatives are actually used and the related institution building. If the financial crisis has exposed the development of financial derivatives in western financial markets as somewhat too rapid, the situation in China is quite different. There are proper regulatory systems that regulate the OTC derivative market in china as NAFMII (National Association of Financial Market Institutional).

• Recommendations• As Chinese products are now available in international market so

derivatives can also be used as arbitrage opportunity to gain the price benefits between different markets

• Chinese market mainly focuses on commodity market it should also focus on exchange rate derivatives because of international trade

• Chinese derivative market should establish the use of options for the flexibility to exercise the right or not

• Chinese derivative market should introduce the derivatives in other currencies which are acceptable in Taiwan, macau and hongkong because The renminbi (RMB) is the official currency of China (People's Republic of China). Renminbi is legal tender in mainland China, but not in Hong Kong, Taiwan, or Macau.

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