Stock index futures launched in China
By Patti Waldmeir in Shanghai
China passes an historic milestone on the path to a market-driven economy on Friday as stock index futures begin trading on the mainland.

After more than three years of practice trading, China’s stock market regulators are allowing select mainlanders to trade equity-based derivatives in their home market.

The introduction of index futures is part of a broader transformation of the mainland stock markets this year: short selling and margin trading were introduced on a trial basis on March 31.

Such tools are important to allow traders to profit from falling as well as rising markets, and to hedge their positions against downturns in China’s notoriously volatile markets, which surged 80 per cent last year after falling 65 per cent the year before.

Commodities such as gold, soybeans and fuel oil have been traded in Chinese futures markets for years, but the launch of stock index futures is particularly significant because they will be China’s first financial futures since the mid-90s.

China’s government bond futures market collapsed in 1995, just two years after it started, as market manipulation spun out of control amid a lack of regulatory oversight.

The first index futures, agreements to buy or sell an index at a pre-set value on an agreed date, will be based on the CSI 300 index, which tracks the Shanghai and Shenzhen markets. The first contracts will be for May, June, September and December.

In a front-page editorial earlier this week, the China Securities Journal hailed index futures as a “milestone” that will have a stabilising effect on Chinese markets and enable them to evolve “from prosperity to maturity”.

But Beijing’s fear of the risks involved is so great that it plans to keep most players out of the market, at least initially.

Chinese officials say that for now, risk prevention is their top priority. “Derivatives like futures are a ‘double-edged sword’ that is not only a tool to manage risks but is also a source of risks unless it is used appropriately,” the People’s Daily said last week.

Securities regulators have introduced stringent requirements to keep speculators away. Index futures investors must pass an examination – broadly equivalent of the UK driving test – and meet tough criteria for educational background, credit history, monthly salary and liquid assets.

They must make a minimum deposit of Rmb500,000 ($73,238) to open a trading account, and prove they have completed at least 20 mock stock index futures trades or executed at least 10 commodity futures trades in the past three years. They also must pay cash deposits equivalent to 15 per cent of the contract value for May and June contracts and 18 per cent for longer-term contracts. Foreigners are not allowed to trade index futures.

The restrictions are mostly designed to keep out the small retail investors who are the lifeblood of China’s volatile markets – but also the most speculative investors in markets.

Official figures released earlier this week show that only about 6,000 index futures trading accounts have yet been opened. Most have so far been opened by commodity traders, experienced in futures investing.

As a result, most market analysts say the immediate impact of the move is likely to be small.

“I don’t think we’re going to see huge volumes initially,” says Dean Owen, Shanghai-based chief representative for Newedge, the French futures brokerage, which has a joint venture with Citic Group in China.

“But the future looks bright,” he adds. “Over time, as it becomes clear that the system is working properly, then [regulators] will possibly reduce the barriers to entry.”

In time, brokerages hope regulators will encourage greater investor participation by introducing smaller versions of the futures contracts (like “mini” S&P 500 index futures in the US) or by reducing the required margin or the required capital needed to open an account.

“The first step is to get the toolbox ready,” says Jerry Lou, China equity strategist at Morgan Stanley. “Then people get used to using those tools, and finally they will be fully workable. It may be a multi-year thing but the direction is correct.”

The goal is to improve capital allocation in the Chinese economy, and bring the Chinese stock market closer into line with western norms – part of a drive to transform Shanghai into a global financial centre by 2020.

Chinese regulators have high hopes that the introduction of more sophisticated forms of trading will improve market stability, even though the existence of such tools in Western markets did little to guarantee stability during the global financial crisis.

Chinese brokerages are predicting that index futures trading will boost equity market trading, saying China could overtake the US as the world’s largest in terms of trading value.

Hedge funds and other institutional investors will have a greater incentive to trade once they can hedge their risks. Experiences in other markets such as Taiwan and Japan suggest that trading volumes could, in the long term, increase by as much as 50 per cent, according to Morgan Stanley.

But by barring foreigners from index futures trading, China’s regulators underline a fact that outsiders often ignore: only less than 1 per cent of the Chinese market capitalisation is currently open to foreign investors.

China remains largely insulated from the outside world, and the introduction of new sophisticated trading tools will not change that – at least not overnight.