Changing China

The nation is ready to move its capital markets forward

Originally published in the September 2009 issue

As international markets tumbled in September 2008 in the wake of the spectacular collapse of Lehman Brothers and the nationalisation of AIG, securities regulators around the world began to clamp down on short selling. The US Securities and Exchange Commission promulgated an order to halt short selling in financial stocks in order to “protect the integrity and quality of the securities market and strengthen investor confidence”, while the Australian Securities and Investments Commission banned all short selling in stocks to protect the Australian financial markets. Financial regulators in the UK, in Taiwan and in other countries took similar measures. Actions by the Chinese government stood out in sharp contrast. The State Council, which is the primary administrative authority in China and is headed by Premier Wen Jiabao, based on a recommendation from the Chinese Securities and Regulatory Commission, or CSRC, agreed to permit Chinese investors for the first time to borrow stock. This decision would theoretically permit short selling and margin lending. It has now been nearly one year since this approval and yet China seems no closer today to the actual launch of short selling than it was then.

The false start of short selling in China’s equity markets, known as the A-share market, has the feeling of déjà vu all over again. In 2006, the market was abuzz with the opening of the China Financial Futures Exchange, which was established to be the first exchange for the listing and trading of index futures contracts, as well as other financial derivatives. The Futures Exchange would allow investors for the first time to hedge their long exposure as well as to speculate and profit from drops in the underlying indexes, upon which the futures contracts are based. It was widely believed, based on comments from the CSRC, that index futures would begin trading by the start of 2007. By late 2007, CSRC Chairman Shang Fulin stated that all systems and technical issues had been completed, but final “preparations” were still needed. The New Year came and went. Once again the market speculated that futures trading would begin following the 2008 Beijing Olympic Games with contracts to be based on the CSI 300, a market-cap weighted index representing the 300 largest companies in the A-share market. The next speculated launch date was the start of 2009. Today, the Futures Exchange’s own website states that “it won’t be long for the CSI 300 index futures…to be launched.” Many investors are wondering whyindex futures trading has not yet occurred.

Bond futures unsuccessful
China’s unsuccessful experiment with a bond futures market in the mid-1990s goes a long way to explain why index futures trading has been so slow in launching and why short selling is even further away from being a reality.

In late 1992, China launched a market in government bond futures. Due to insufficient institutional interest, the market was opened to the public in 1993. However, it was plagued by rampant price-manipulation and collusion, frenzied and chaotic speculation, and weak governance. In one example of the many problems, price manipulators who held long spot positions colluded before government bond futures matured by accumulating large positions in long futures without the intention to offset. This caused spot prices to rise sharply. Instead of creating a more transparent and stable market for government bonds, the bond futures contracts actually led to higher market volatility, causing painful disruptions in the spot market. As there were no securities laws, and a lax and ever-evolving regulatory environment, problems persisted and multiplied. After less than two years of operation, the market was closed down. The Chinese government certainly wants to avoid an embarrassing repeat of the bond futures market fiasco, this time under the spotlight of the global financial press.

Before the launch of either short selling or index futures trading is possible, the Chinese must address the problems that doomed the bond futures to failure. Specifically, the markets for any new financial instruments must be well designed and tested, well regulated and have effective enforcement mechanisms. Failure in any area could result in a repeat of the problems which doomed bond futures trading. So where does China now stand on the path of financial development, specifically with the launch of short selling and index futures?

China has completed its preparations for the launch of index futures trading and literally could launch at any time. With regards to organisation and membership, systems and testing, the Futures Exchange is almost fully operational. The exchange currently has 75 members, consisting of 12 general clearing members, 39 trading and clearing members, and 24 trading members, according to the China Financial Futures Exchange website, However, at this point, no special trading members have been approved. The special trading members are the banks that will affect clearing and delivery for trading members, and they are therefore crucial to the operation of index futures trading. China Merchants Bank, China Minsheng Bank and others are awaiting approval as special trading members. It is expected that once special clearing members are approved, the CSRC and the China Banking Regulatory Commission will then jointly promulgate the regulations for special clearing members and thereafter the launch of index futures would be imminent. While qualified foreign institutional investors have not yet been approved for participation, it is widely believed that they will be able to participate.

The systems for settlement and clearance have also been tested during more than two years of mock trading. The Futures Exchange uses a completely electronic trading system with no floor traders. All trades are automatically matched and executed by the trading system according to the principles of price priority and time priority. From this perspective, the systems are operational and have been working without material problems. In fact, the exchange could have been ready for the launch of index futures trading as early as the start of 2007, as even by that time the exchange had completed product design, rules setting and technical preparations. However, technical problems in the systems of exchange members were a concern. Market participants at major securities companies now believe that they are ready. Moreover, their experience in trading commodity futures has helped them to prepare for thelaunch of index futures trading. Many international investors will be surprised to learn that in the last year China has quietly become the second largest commodity futures market in the world, second only to the US. With four commodity futures exchanges – Shanghai Futures Exchange, Zhengzhou Commodity Exchange, Dalian Commodity Exchange and China Financial Futures Exchange – China’s commodity futures markets recorded 1.36 billion lots in gross trading volume and 71.9 trillion yuan in gross trading value in 2008. So from a systems and operational preparedness standpoint, both the Futures Exchange and market participants are ready to launch.

Short selling undeveloped
Short selling is much less developed than futures trading. While its experience with the failed bond futures trading experiment in the mid-1990s and its more successful recent experience with commodity futures trading give China a solid footing to launch index futures trading, it must break new ground with short selling. Major securities brokers have been actively preparing for the launch, including by implementing systems, establishing departments and training personnel, as well as doing internal trade simulations. However, to date, short selling has not been commercially launched in China, and there is no uniform clearing or settlement system in place. The most concrete step forward occurred on 5th October 2008, when the CSRC announced a pilot securities lending dealing program. During the period from 25th October to 8th November 2008, 11 securities firms, including Galaxy Securities and China Merchants Securities, successfully completed preparations. On 25th November 2008, the CRSC gave non-binding guidance to candidates for selection with regard to their securities lending plans and application materials. However, since the qualifications and criteria for pilot securities firms are yet to be determined by the CSRC, no securities firms have submitted applications. Securities firms say they are actively preparing for the pilot program and will submit their applications immediately after the CSRC has announced what are the qualifications and criteria. With this in mind, it is clear that short selling is not around the corner, and very likely a long way off.

Advances in regulation
From a legal, regulatory and enforcement perspective, authorities are far more advanced than during the days of the bond futures scandals. Despite the common perception that China lacks a reliable legal regime, China has in fact made significant strides in creating a comprehensive system to govern and police index futures trading. With regards to futures trading, a three-layer legal and regulatory system was put in place in 2007, which includes the State Council’s administrative regulations, the CSRC’s regulatory measures, and the Futures Exchange’s rules and measures. The State Council’s administrative regulations set the framework to regulate the trading of financial futures contracts and the subject matter of financial futures contracts, as well as establish the functions that a futures exchange must address, including risk management, clearance and settlement mechanisms. The CSRC’s regulations create a more intricate regulatory regime that addresses the functioning of futures exchanges, exchange participants, risk management and protection of investor interests.

In addition, in 2007, the CSRC and the Ministry of Finance jointly promulgated rules regarding the protection of investor funds. The Futures Exchange itself also has created a set of detailed rules covering areas such as clearance and settlement, member administration, risk controls, hedging, and procedures for dealing with violations of its rules. It is safe to say that China now has an adequate legal and regulatory system in place that lays a foundation for the successful launch of index futures trading.

The legal and regulatory regime governing short selling also exists. Most of the laws and rules were enacted and promulgated in 2006. The CSRC issued Measures for the Administration of Pilot Margin Financing and Securities Lending Services of Securities Firms and Guidelines for the Internal Control of Pilot Margin Financing and Securities Lending Services of Securities Firms. These rules open the door to covered short selling, but would prohibit naked short selling. In addition, the Shanghai Stock Exchange and the Shenzhen Stock Exchange have each issued rules related to margin financing and securities lending, as has the China Securities Depository and Clearing Corporation. Given the fact that actual implementation of short selling has not begun in earnest, one could expect further legal and regulatory developments to continue before the actual launch some time off in the future.

Nevertheless, given that financial industry participants have been preparing for the last several years and have been gaining practical experience in a now firmly established and tested commodity futures market, and that a legal and regulatory regime has been in place since 2006 for short selling and since 2007 for index futures trading, many investors are left wondering what the hold up is. Certainly the Chinese government is keen to develop its financial market. It is widely recognised among highly placed financial officials, including CSRC Chairman Shang Fulin, that a more mature and sophisticated financial market is imperative if China’s capital markets are to compete internationally and fulfil the government’s goal of being a global financial centre by 2020. However, in the view of the Chinese government, more important than an advanced financial market is a healthy and stable financial market. China has always placed stability above progress. The latter must serve the former, as the progress has proven in many countries to be destabilising if not managed effectively. It is only through this lens – the delicate balancing act of progress and stability – that China’s halting efforts in moving its financial markets forward may be understood.

Stability paramount
For a country in which a small number of Communist officials rule 1.4 billion people with no political mandate, stability is paramount. The government has legitimised itself in the last three decades by taking hundreds of millions of people out of poverty and turning the country into the world’s third largest economy. Implicitly, the Communist government must provide economic growth, and anything that may result in instability is shunned. Its hesitancy to open up the capital accounts is a good example of the government’s characteristic temperament. While the Asian tigers of Taiwan, South Korea and Singapore opened up to the free movement of foreign capital, they each discovered in the 1997 Asian Financial Crisis the dangers of fickle foreign investors, as capital fled creating massive economic instability. China, with a closed capital account, rode relatively unscathed through that crisis. Chinese leaders learned from the mistakes of others and have been very slow in making changes. This caution has proven the Chinese to be wiser than many of their so-called more mature counterparts in the developed world. With the bad experience of the abortive bond futures market almost 15 years behind them, and with a long track record of success in the commodity futures market, Chinese officials are likely looking to introduce index futures trading when market conditions are more stable. The hold up is not due to systemic weaknesses in the financial system itself. Short selling, in contrast, still requires further development and testing before it could be launched. In general, though, China has created a sounder legal and regulatory regime, as well as encouraged the growth and maturity of the financial community that will participate.

However, while regulators, exchanges, securities companies, banks, and clearance and settlement companies have all gone a long way to prepare for the launch of index trading and, to a lesser extent, short selling, when investors will actually be ableto begin to participate is still very much an open question.

Chinese officials are taking a conservative approach to ensure success. While they recognise that index futures trading may result in speculation and widen volatility, they are likely gaining more confidence that the market is mature and prepared enough to cope. Bangmin Wang, a partner at Tian Yuan Law Firm, a leading Chinese legal practice specialising in securities law, agrees: “They tend to believe the launch of index futures trading and short selling can help to improve trading mechanisms and investment strategies, and strengthen the price-finding function of the capital markets – in particular, by providing products and means that allow investors to hedge systematic risks and profit even in declining markets.”

It is this belief that has pushed the Chinese to move methodically and systematically in laying the groundwork for the launch of index futures contracts and short selling. Whether the launch of index futures trading occurs following the October celebrations of the 60th anniversary of the founding of the People’s Republic of China or later at year’s end, China will be ready to move its capital markets one more step forward to global leadership.

Alan Landau is the president of Marco Polo Pure Asset Management, an investment manager specialising in China’s A-share market. He leads Marco Polo’s operations and is a member of its investment committee.