A Very Opinionated Look at the China Equity Derivatives Market
In this article we will examine the current landscape of China’s Equity Derivatives market. It involves 3 sections where we first look at the key milestones of derivatives to see how we got here; then a comparison between the Chinese markets to a matured one using the US as an example; and finally a summary on why we are here and what is the way forward.
Milestones of Derivatives
“If any one owe a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for the year.”
The 48th law in the Code of Hammurabi from 1750 BC is commonly recognized not only as the oldest written body of laws but also the earliest cradle of derivatives. This can be seen simply as a form of commodity linked notes enforced by law.
If we are strictly speaking about contracts, then one need to look only a little further down the road, where merchants in Ancient Mesopotamia enter into contracts stipulating the quantity, quality and price of commodities to be paid for at a future date. These were essentially a form of modern day forward contracts.
Now let’s take a quick jump to the middle age; we see a form of derivatives called the Bill of Exchange, which is a promise to repay a certain amount of money in a different location, a different currency at a future date. This is akin to the FX Forward we are so accustomed to. In 1539, the Charles V imposed a regulatory framework which recognized the transferability and negotiability of these bills. Naturally trading and speculation of the bills soon followed, this was further boosted by the development of CFDs (contract for differences) where only the profit was settled between the counterparties. It didn’t take long until the government realized CFDs gave traders too much leverage to speculate, these contracts were promptly banned in 1541, only 2 short years later.
Soon in 1602, we witnessed a great piece in the history of economics and finance, namely the Dutch East India Company. However catastrophic the event was, 2 vital developments were made to the equity derivatives during this time:
Forward contracts on the shares settled as contracts for difference were fervently used;In 1608, a syndicate formed by Isaac le Maire borrowed shares and then sold them, which was effectively the first short-selling attack in the history. One of the consequences of the attack was the ban on short selling in 1610, albeit having never been effectively enforced.
Moving on to the late 17th century through to early 18th century, we have the first commodity exchange market being formed in Japan, the Dojima Rice Exchange. The exchange mainly traded “prepayment bills” where sellers issued bills to buyers on the basis of rice that had yet to be harvested. Again, these are simply a form of commodities forward contracts. The Shogunate (the ruling government at the time) imposed regulatory rules on rice trading; however these rules were enforced only when the prices fell too low or too high. Perhaps the most noteworthy thing being, the Shogunate charges fees for membership and access to the exchange, and in turn regulates it and established clearing houses which assumed contract obligations in the case a trader defaults. The Shogunate effectively served as CCP (Central Counterparty Clearing) for the Dojima Rice Exchange. The establishment of a CCP gave a giant boost to speculations; there were as many as 110,000 bales of rice traded on the exchange while only 30,000 bales existed throughout Japan.
During the same period in England, we have the South Sea Company, another infamous piece of history, and ironically coined the term “bubbles”. The curious development we look for here is how some of the shares were bought. A type of option called “Refusals”, where buyer pay percentage of the issue prices in installments to eventually own the share. They can then give up their rights to the share by simply refusing to pay the next installment. These options would later give birth to modern day Accumulators (or more aptly named “I Kill You Later”). The aftermath resulting in Sir John Barnard’s Act which enforced a ban on options in shares as well as short-selling of shares.
And finally we come to a more modern era; in the 1848 CBOT was created in Chicago. The very first derivatives exchange was established in United States. Forward contracts called “to-arrive” were traded on the exchange. However, due to the varying quality and maturity dates, the demand for storage facilities was too much to handle for the exchange. It soon established a department in 1858 to classify and certify grades of grain, and later standardized contract size, quality and delivery dates in 1865. This gave birth to modern day futures contracts. From then on, US became the core of innovation in derivatives. In 1972, the CME introduced the very first futures contracts written on financial instruments, the FX futures on the Canadian dollar, British pound, German Deutschemark, Japanese yen, French Franc and Mexican Peso and Italian Lira futures. Later in 1975, the CBOT launched the first interest rate futures written on Government National Mortgage Association. Last but not least, in 1982, the CME created the first successful stock index futures, the S&P 500 Index futures.
As we marched forward in time, a recurring theme has been observed, that is:
The root of derivatives has always stemmed from commercial hedging needs, which later give rise to speculation through leverage, and then regulated to calm the chaos which soon followed.
In this case, China was no exception. A brief timeline of China’s Equity derivative market paints a similar picture:
In 1984 July, PBOC approved China’s very first IPO for the Shanghai Feilo Acoustics Co., Ltd;In 1990 December, both the Shanghai and Shenzhen stock exchange was established late 1990;In late 1992, a rudimentary type of OTC market was formed around HongMiaoZi (紅廟子), a mere 200 meter street in ChengDu. There it traded all types of securities, from stock, stock options, to bonds. What happened there was what has always happened throughout history: rampant speculation and greed. Some would recall:
which roughly translate to
“Some merchants on the street and older investors could still recall, crowd would assemble at sun rise just to get a better seat to trade at the market.
You can buy stock at this end of the street, walk down the street and sell it for double the price at the other end“In 1993 May, government intervened and banned trading in HongMiaoZi;In 1995, both stock exchange re-imposed rule intraday trading, enforcing a T+1 cycle which was remain enact till this date;In 2010 April, index futures started trading in CFFEX;In early 2014, China’s shadow banking system reared its head. By packaging structured products through layers and layers of financing, it gave overwhelming leverage to investors with little risk appetite. One with no former investment experience can easily obtain 10 times leverage or more at a broker;In 2015, the China Equity Market entered full on bull market, the ShangHai Composite Index rose from 2000 to 5000 in less than a year. It was obvious to any sane person that a bubble is brewing. Regulators started rushing to look for ways to contain the bubble;In the 2 short month following reaching its peak in June 2015, the composite index dropped over 40%;In 2015 August, CFFEX restricted futures trading to bare minimum, the China index futures market is now a shadow of what it once was, with average volume dropping back to what it was 4 years ago;In 2016 Jan, regulators introduced circuit breaker similar to what was used in the US. The concept was well intention however ill received, causing a more than 10% drop in the index the same week. Regulators soon removed the circuit breaker mechanism, ending its less than 1 week life span.
It is perhaps tragic and inevitable that history was doomed to repeat itself, almost every market go through its own bubble and burst phase, and China was no exception.
A Comparison between the US and China Equity Market
The US Equities derivatives market was by far the most sophisticated and liquid in the world, the Chinese market was little or even insignificant in comparison, but why? We know US had a more than 100 year lead to China; however this should not be the only force in play. I believe the key lies in:
A critical mass in the market;A health ecosystem;A comprehensive regulatory framework.
Critical Mass in the Market
The financial market is extremely complex and sophisticated. However, we can often measure a market’s maturity simply by its size. One would call it economy of scale, but I believe it can be simply concluded as the greed of everyone involved. The bigger the market, the more money is involved, the more money is involved the more investors start looking at different way to profit at every opportunity.
Below is the top 10 exchange in the world ranked by their end of 2016 market capitalization:
While all 3 of the China’s exchange including Hong Kong ranked amongst the top 3in the world. We should also note that the 2 US exchanges NYSE and NASDAQ are bigger than the 8 other exchanges added together.
Next, we should look at the statistic more relevant to our discussion: the derivatives market’s trading volume. The table below shows the top 10 trading volume on index futures:
The difference here is even more obvious: all other exchanges in the world’s trading volume sums up to be 59,230,259 million USD, which still came short of the CME Group alone.
Finally, while China’s single stock option market is not established yet, we can look at the figures below to see the gap between US and the rest of the world in terms of volume traded:
The derivatives market depends on many other things to stay alive and healthy; it is a derivation of its underlying and cannot exist in isolation. There are too many components and too many different ways they interact, the graph below divide them into 3 core category, and 4 key pillars inside each category to show how they interact and enhance each other.
On the left there is the US Equity Market, while on the right we have the China Equity Market. The graph illustrates the missing components as well as the weakened links.
Comprehensive Regulatory Framework
A stable and matured regulatory framework is essential to a matured derivatives market. One can write a million pages on how different laws are worded or how they are enforced. One of the cornerstones in derivatives trading is the ISDA and its’ tacked on clause CSA.
The ISDA Master Agreement outlines the standard terms to be applied to a derivatives transaction between 2 parties; it allows different counterparties to negotiate terms of an OTC transaction on a common ground. Its tacked on clause CSA stipulates the rules governing the mutual posting of collateral to provide credit protection for both parties.
Unfortunately, ISDA is not exactly enforceable under the Chinese legal system, instead we have NAFMII. While there is no telling which one is better, there’s no doubt they are different in many ways. When things go south, having different rules of law can make OTC transactions wildly different. For example, one would recall the case involving “Hermitage Development” and “Unicredit Bank”; the case can be simplified as such:
Hermitage and Unicredit entered into a IRS trade;Hermitage suffered losses but wanted to “walk away” without paying any termination costs;Russian court ruled in favor of Hermitage due to a Russian law stating
&#34;a right of any party to terminate the Agreement at any time if there are no outstanding obligations&#34;;Since Hermitage and Unicredit has yet to make any payments, when there is no payment obligations, there is certainly no outstanding obligations, it is therefore Hermitage’s right to terminate the agreement, i.e. the IRS trade.
Such an incident is why having NAFMII instead of ISDA has made OTC transactions less appealing or much more expensive for foreign counterparties.
Derivatives has existed throughout the course of human civilizations, its origin came from a need for hedging commercial activities. Whether it’s for producers to secure funding, or merchants to secure raw materials, it has always been driven by economic necessities.
However, speculators have always found way to abuse the leverage it empowers them with. We have seen many bubbles created by speculators and public frenzy, as well as the resulting crack down by regulators. The same cycle has repeated throughout the history of western world, and the same has happened in China.
There will always be boom and burst in the history of finance, perhaps derivatives were the devil in some, and perhaps it accelerated a few. However, there is no denying that a healthy and sophisticated derivatives market allows many commercial hedging activities to be carried out with little friction; it therefore enhances economy and optimizes resource allocations. By observing the largest derivatives market (the US) in the world, we find that the size of the market, completeness of the ecosystem and a rigid legal framework should be the correct way forward for China.