China took another step to open its domestic futures market to the world in August when the Shanghai International Energy Exchange listed yuan-denominated futures on natural rubber. The launch was the latest move by China to internationalize the contracts listed on its futures exchanges, which has led to a flurry of activity among overseas financial firms seeking access to this large and rapidly growing market.
INE, a subsidiary of the Shanghai Futures Exchange, was set up specifically to attract foreign firms. Its first contract, a futures contract based on the price of imported crude oil, was launched in March 2018 and by September 2019 approximately 20% of the volume was coming from foreign firms.
The INE's listing of futures on rubber, known in the industry as TSR 20, adds another important industrial commodity to the Chinese futures market. China is a major importer of TSR 20, mainly for use as a raw material for tires, and the addition of TSR 20 futures provides the automotive supply chain with an important risk management tool. By listing the contract on INE, the authorities are providing another opportunity for foreign firms to participate in this marketplace.
Two other exchanges, the Dalian Commodity Exchange and the Zhengzhou Commodity Exchange, are also taking steps in this direction. Both exchanges primarily serve domestic market participants, but over the past 18 months they have been permitted to open certain contracts to foreign firms—iron ore in the case of DCE and purified terephthalic acid, an important feedstock for the plastics industry, at ZCE.
The iron ore and PTA contracts are extremely liquid and rank among the most heavily traded commodity futures in the world. A small number of overseas firms have been able to participate indirectly through registered entities in China. Under new rules introduced by the exchanges, however, overseas firms no longer have to go through the cumbersome process of setting up an onshore entity, removing an important barrier to international access.
Fuel and Agricultural Futures Next in Line
Market participants say other contracts are expected to open to international firms over the course of the next year, including futures for liquefied natural gas, gasoline and diesel on the Shanghai Futures Exchange. Any such move will require approval from the China Securities Regulatory Commission.
DCE is also looking to open its futures for soybean meal, soybean oil and palm oil to international participants, a spokesperson for the exchange told MarketVoice, adding that it is drawing on its experience with "internationalizing" its iron ore contract. "DCE will continue to promote the process of opening up to the outside world…and the related work is steadily advancing," the spokesperson said.
Allowing international participants direct access to futures on China's exchanges is a key step in the internationalization of China's financial market and its currency. The move is also part of China's bid to have more of a say in pricing major commodities sold to Asia. The country is the world's largest importer of iron ore—the key feedstock in steelmaking—and the world's biggest importer of crude oil, surpassing the U.S. in 2017. It is also the biggest importer of plastic and soybeans.
“The liquidity will improve with the participation of international investors and the price discovery function will be more viable.”
J.P. Morgan Futures Co. Ltd.
Despite China's outsize role in the global trade in physical commodities, its relationship to global commodity prices has been limited. Although international trading firms have been keen to access its commodity exchanges, state restrictions on foreign participation and currency flows prevented local contracts in China from gaining global prominence.
With the opening up of these contracts, the country is looking to develop its exchanges as venues for international price discovery, with the aim of gaining greater influence over the pricing of its major commodity imports and eventually having its locally listed contracts accepted as international price benchmarks. The goal with crude oil, for example, is to create a China-based benchmark for the Asia-Pacific region as an alternative to the two main benchmarks currently used in the global oil market—the New York Mercantile Exchange's West Texas Intermediate and Intercontinental Exchange's Brent.
Rochelle Wei, chief executive officer of J.P. Morgan Futures Co. Ltd., commented that the internationalization of China's commodity futures markets will benefit the domestic market. "The liquidity will improve with the participation of international investors and the price discovery function will be more viable," she said.
The Shanghai-based futures broker, which is a joint venture of J.P. Morgan and a local firm, is a trading and clearing member of the three main commodity futures exchanges and was one of the first foreign firms to become a member of INE. J.P. Morgan offers access to the crude oil, iron ore and PTA contracts to its clients both onshore and offshore and is working to facilitate access to the TSR 20 product offering. Wei added that J.P. Morgan has seen an uptick in demand for trading of these products from its overseas clients.
New Rules for Overseas Intermediaries
Before 2018, the only way to trade in China's commodities futures market was by establishing a local entity. This was a complex process fraught with difficulties, particularly with transferring money in and out of the country.
Under new exchange rules that came into effect last year, international investors are now permitted to participate directly and trade the four contracts either through a domestic Chinese futures broker that is a member of the exchange, or through an "Overseas Intermediary", a category of broker that does not trade directly at the exchange but has authorization to set up accounts with domestic futures firms on behalf of international clients.
Even though the contracts are denominated in the Chinese currency, international clients can use U.S. dollars and offshore renminbi to meet the initial margin requirements and can trade free of Chinese taxes via an Overseas Intermediary. With INE, a third way to participate is through a qualified overseas brokerage firm approved by the exchange.
"The Overseas Intermediary route is an important step towards the internationalization of the Chinese domestic futures market," said Jeremy Goldwyn, managing director at BANDS Financial, a Hong Kong-headquartered futures broker and one of the first brokers to become an OI for the three commodities exchanges.
"OIs help reduce concerns and issues of currency and taxation as all trade profits are tax-free in China and guaranteed convertible into U.S. dollar, as opposed to clients having to decode the previous State Administration of Foreign Exchange regulations concerning foreign exchange transactions," Goldwyn said.
He cautioned, however, that the account opening and documentation process is still a complex procedure. "OIs are required to register their end clients directly with exchanges and the China Futures Margin Monitoring Centre, which is not global industry practice and can limit the marketability of the OI concept to western participants," he said.
Foreign investors may also be cautious about participating on markets that could be subject to high levels of volatility due to the influence of China's retail investors and speculators who do not trade based on market fundamentals and because of China's capital controls.
Despite this, data suggests that overseas participation is slowly gathering steam. So far INE has approved the filings of 58 OIs to provide brokerage services for overseas investors, with international participants contributing 20% of the total trading volume and accounting for 25% of the open interest. A year prior in September 2018 the proportion of international investors was about 15%, and data from July 2018 shows international investors at just 5%.
While DCE does not break down its data similarly, the exchange said that at the end of August 2019, 156 overseas clients from 14 countries had opened accounts and 95 overseas clients had been involved in the trading of iron ore futures. This was a rise from 125 overseas investors that opened accounts to trade the contracts by the end of April 2019.
Access Through Technology Partnership
Alex Lambert, who heads global sales at CN First International Futures, a Hong Kong-based broker that has qualified as an OI, said he is seeing interest from traders as far afield as Chicago, Houston, London, Amsterdam and Singapore for iron ore and crude oil futures contracts. CN First has partnered with Trading Technologies, one of the top vendors of trading systems in the futures industry, to provide international traders with direct market access to crude oil, iron ore and PTA futures through the TT platform. It is also finalizing internal testing for access to the TSR 20 contract with clients ready to start trading as soon as it becomes available on the platform.
“For both domestic and overseas players there are interesting new spread opportunities to look at as iron ore, crude oil and rubber are all traded on other exchanges.”
CN First International Futures
Talking about the opportunities that trading in China's futures market presents, Lambert said one area of interest is the arbitrage between onshore and offshore markets. Iron ore, for example, is listed on the Singapore Exchange, and rubber is listed on both SGX and the Tokyo Commodity Exchange. "For both domestic and overseas players there are interesting new spread opportunities to look at as iron ore, crude oil and rubber are all traded on other exchanges." oil and rubber are all traded on other exchanges."
Straits Financial Services, a Singapore-headquartered broker and OI, says it is also seeing increased trading demand from clients for iron ore and crude oil as these commodities have a larger trading base compared to PTA and rubber. The company brokered the first trades for all four contracts launched by INE, DCE and ZCE through exchange clearing member Xinhu Futures Co. Ltd. "We believe these contracts are a test for a larger initiative to open up the domestic markets," said Roger Quek, managing director of Straits Financial Services.
"There is good international interest wishing to participate, primarily those with the ability to find arbitrage opportunities between the global markets versus the domestic contracts," said Quek. "[The opening up of futures markets] also offers the opportunity to trade at a price that is more reflective against the Asian markets rather than taking a foreign benchmark."
In addition to internationalizing more contracts, China's commodity exchanges are looking into accepting other currencies as margin deposits. A spokesperson for DCE said, "In May 2018, overseas traders were introduced to the iron ore futures, and foreign investors could use U.S. dollars and offshore renminbi as futures deposits. At present, DCE is studying and demonstrating the use of other currencies as iron ore futures margin to facilitate the participation of more foreign traders."
More currencies and contracts on a relatively short-term horizon would be a welcome and positive move to overseas participants active in the market.
"The broader the offering, the more likely overseas clients will attempt the [account opening] process. Up until now a good portion of clients utilizing OI have been of offshore Chinese origin, seeking to take advantage of the simplicity and efficiency of trading domestic/ overseas arbitrage in one account rather than running each separately," said Goldwyn.
"As the potential portfolio expands, international access to the Chinese marketplace, as well as international arbitrage, will become simpler," he added. "The mainland contracts will become more familiar and will lead to further synergies and trading opportunities between global contracts. This will increase the possibility of Chinese benchmarks and enhance mutual understanding of two different marketplaces."