Central Banking

Future-proofing risk in the Chinese economy

Zhang Shenfeng, chairman of the China Financial Futures Exchange (CFFEX), argues that a multi-layered capital market must include an active financial futures to facilitate real-world risk management
Zhang Shenfeng of the China Financial Futures Exchange (CFFEX)

The development of the financial futures market is an important building block for a multi-layered capital market, which should include primary issuance, secondary circulation and tertiary risk management services to fully realise an effective allocation of risk and resources. The derivatives market, especially the financial futures market, is an indispensable part of the system. Looking at the past decades of capital market development around the world, whenever there is a spot market, there are also futures and options markets irrespective of whether the underlying are stocks, debt or foreign exchange. There are no exceptions in any major world economy.

Building risk platforms

Thanks to the rapid growth of Chinese financial development over the past few years, up to the third quarter of 2014, financial assets reached 190 trillion yuan, bank deposits 113 trillion yuan, household savings 50 trillion yuan, debt market value of 32 trillion yuan, stock market value 28 trillion yuan and foreign reserves of $4 trillion.

As a result, small fluctuations in equity, interest rate or currency markets will have a major impact on economic and social wealth. So there is a stronger demand for risk management capabilities and an urgent need to have more financial futures and other tools to help hedge against risk.

China needs to build a management platform in a faster and more comprehensive manner to provide instruments and channels for managing risk, especially credit risk.

China's financial futures market

China's financial futures market has essentially realised its basic objective. Despite a late start - China did not create its first financial futures product (the CSI 300) until April 16, 2010 - the past four years have seen the positive influence of this index on the overall capital market.

First, stock index futures have acted as a cushion and stabiliser, improving the intrinsic stability of the stock market. Since the Hushen 300 futures started trading on the market, the number of days that the index had risen by over 2% has dropped from 168 to 69 - a decrease of 58.9% - while the number of days that the index dropped by over 2% has declined from 155 to 64, a decrease of 58.7%. Additionally, the annualised volatility of the stock market has dropped by 25%, indicating a decline in systematic risk in the market.

Second, stock index futures have increased innovation in the capital markets, attracting a range of institutions and long-term capital, thereby boosting the core competitiveness of the stock market.

For example, since 2010, financial institutions have issued 1,143 stock products, 770 of which are stock index futures, taking 67.4% of the total, with an asset size of over 120 billion yuan.

Third, stock index futures have acted as a catalyst for the creation of a more prudent investment culture within the stock market. Investors avoid risk through futures, for instance, by purchasing insurance against a fall in their equity portfolio
holdings.

The next financial futures products to debut in recent years were five-year treasury-bond futures. These derivatives have been trading on the market again for over a year, and the market has operated smoothly while gradually helping to boost development of the spot market for treasury bonds.

At the same time, the CFFEX has actively adapted to market developments by optimising rules, reducing costs, enhancing efficiency and improving the function of the market. It has achieved several goals:

  • Reduced the transaction fee for index futures by 50% (to 0.025%), which has benefited the market and investors.
  • Gradually increased the position and day open limit. The position limit was raised from 100 shares to 300 shares, then 600 shares to the current 1,200 shares, which has helped to meet hedging and trading needs.
  • Implemented a trade-optimised deposit system, which has reduced to 10% the deposit needed for index futures. With the improvement in supervision and risk resilience of participants, there is room for further reduction.
  • Created a management support system to meet the needs of all kinds of risk management, simplifying the business process and improving the transparency and efficiency of rules and regulations.
  • Diversified the types of trading, and implemented safer and more efficient guidelines, with the aim of facilitating innovation and the balanced development of the market.

Future solutions

Although China's financial futures market has made some progress in recent years, it is still in the early stages of development because of its late start, slow growth, lack of variety and small scale. The development and function of the futures market has therefore been limited and far from sufficient to meet the increasing needs of risk management. The factors that limit the development of the futures market stem mainly from ignorance and prejudice towards futures, as well as a lack of experienced people. Therefore, the futures market needs to be developed in three aspects.

First, there is a need to deepen the understanding of financial futures, overcoming ignorance and prejudice. At present, there is not enough knowledge and understanding about the emergence of the culture of hedging. Some parties have even blamed stock index futures for the continuous decline of the stock market in the past. Second, there is a need to learn lessons from the international financial markets and avoid misunderstandings.

For example, a major source of the 2007 US crisis were subprime mortgages, derived from multiple securitisations that grew into a derivatives market worth tens of trillions of dollars. These multidimensional, highly leveraged derivatives no longer represented their early foundation of sharing mortgage risk, and ultimately were instruments of speculation. They highlighted the systematic risks linked with highly personalised, non-standard contracts with low liquidity, poor transparency and insufficient supervision that overtook some of the over-the-counter (OTC) derivatives trading.

Since the G20 consensus in 2009, there have been efforts to address risk in the OTC derivatives business, with high regulatory charges against bespoke products and the requirement for standardised products to be cleared through central counterparty clearings.

Meanwhile, stock index futures and other exchangetraded products operated relatively smoothly during the crisis, seeing increased trading volumes that helped to mitigate and transfer risk. Unlike the US, China does not have sufficient experience in innovation and development. Lessons need to be learned from the subprime crisis, but without overemphasising the risks. We do not want to block innovation and development.

Third, it is necessary to scientifically use the market for economic decision-making. Currently, there are many factors that restrict the development of the financial market, including: the fragmentation in the surveillance of the financial markets; strict administrative control; and the long period before shares are listed on the market.

We should put into practice the proposal raised during the Third Plenary Session of the Eighteenth Central Committee of the Communist Party of China, and actively reduce the length of approval processes, deregulate the market and release more systematic reform benefits. While the government can provide effective macro-control services, the market needs to exert more influence in allocating social resources.

Mature international financial futures products have been used for decades, performing a reliable market risk management function that helps to address price fluctuations and improve economic resilience. It is therefore possible to have the market and government both facilitating development more efficiently.

Currently, the CFFEX is pushing forward the research and innovation of new products, following international market rules and demands, to diversify the system in the following ways:

  • Completing the product line of stock index futures by introducing the CSI 500 and SSE 50 futures on the market as soon as possible, and further extending the product lines for small and medium-sized listed companies to meet all kinds of needs in the market.
  • Completing the product line of treasury-bond futures, developing a 10-year contract and other major term treasury-bond futures.
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