Turbocharging China's financial
markets By Mark A DeWeaver
Participants in China's financial markets
may soon have new opportunities both to hedge
their bets and lever them up using futures,
options and margin trading.
So far seven
put and call warrants have already been issued.
(Puts are options that give the holder the right
to sell the underlying share at a preset exercise
price within a given time period. Calls convey the
right to buy at a pre-set price.) Margin trading
is expected to begin at the end of this year and a
new financial futures exchange, which is likely to
offer bond and stock
index futures, may be in
operation as early as next year. (Margin trading
involves buying or selling using borrowed cash or
stock.)
Many see these innovations as
essential to the development of the capital
markets, but they will also pose difficult
regulatory challenges. Institutions such as banks,
insurers, and fund-management companies clearly
need more hedging instruments to keep pace with
the demand for new financial products created by
China's rapidly growing economy. But in the past,
both in China and elsewhere, such financial
liberalization has often resulted only in new
varieties of speculative excess.
In fact,
bond and stock-index futures and warrants were all
introduced in China in the first half of the
1990s, only to be discontinued because of
irregularities of one sort or another. Margin
trading has never been legal but has also been
quite widespread at various times, particularly
during the bull market of the late 1990s.
The challenge this time will be to avoid
the mistakes made during these earlier episodes,
which led to wildly risky behavior on the part of
institutions lacking adequate capital and
risk-management systems, often operating in a
legal and regulatory vacuum.
A lesson
from history The bond-futures market that
operated in China from 1993-95 is a good case in
point. It was originally introduced to improve
liquidity in the spot market and make bonds more
attractive to financial institutions by allowing
them to hedge their exposure. But there were two
serious problems. First, because most of the bond
issuance up until that time had been directed
toward individuals, institutional investors did
not have large positions to hedge. And second,
most interest rates were set by the government and
adjusted only infrequently so there was also not
much risk against which to hedge.
There
was thus relatively little demand for bond futures
as a hedging tool and the market quickly became
dominated by speculators trading on insider
information, with positions often far in excess of
the limits set by the exchanges. (Bond futures
traded on the Shanghai and Shenzhen stock
exchanges and also on a number of "securities
trading centers" set up by local governments
throughout the country.)
The regulators
finally stepped in after massive losses at
Shanghai International Securities Co (SISCO), at
that time China's biggest broker, which had
unsuccessfully attempted to push down prices by
taking a short position with a notional value more
than eight times the total issuance of the
underlying bond. After this scandal, known as the
"327 incident" after the series number of the
futures contract SISCO was shorting, all
bond-futures trading was indefinitely suspended in
May 1995.
Reviving futures
trading The new financial-futures exchange
announced in January will be able to come online
in a relatively short period of time as it will
use the computer systems of the existing exchanges
and will not require a new building. The first
products to be traded are likely to be bond and
stock-index futures. (The only Chinese precedents
for stock index futures seem to have been
contracts on the Shenzhen Composite and A Share
Indices that traded for a few months in 1993 at
the Haikou Securities Trading Center.)
If bond futures are
reintroduced, there is a reasonable chance for
more orderly trading than was witnessed in the
mid-1990s. Since most of the issuance since 1997
has been taken up by institutions, there are now
banks and insurance companies with large positions
to hedge. At the same time, demand for hedging
instruments should increase if the central
People's Bank of China (PBoC) continues to
liberalize interest rates. And concentrating all
the trading in one place will eliminate the
competitive pressures that formerly caused
exchanges with rival futures contracts to use lax
enforcement of trading rules as a way of
attracting investment.
It remains to be
seen how well any new stock index futures will
track the underlying index. In more developed
markets, index futures prices are kept in line by
arbitrageurs, who (1) take long positions in index
component stocks and short futures when futures
prices are too high and (2) short the index
components while being long the futures when
futures prices are too low. In the Chinese case,
however, even after short selling is legalized it
will still take time for institutions to develop
sources of stock to lend for the second type of
arbitrage trade.
It is also not yet clear
what underlying index might be used, though a
number of candidates have recently been mooted in
the Chinese press. One interesting possibility is
the FTSE/Xinhua China A50, an index of 50
large-cap A shares (FTSE is the Financial Times
index of the London Stock Exchange). This has
already been chosen as the basis for a futures
contract scheduled to start trading on the
Singapore exchange this September.
Legalizing margin trading In a
document dated last December 23, the State Council
called for the introduction of margin trading "at
an appropriate time", and the China Securities
Regulatory Commission (CSRC) has also recently
released draft margin-trading regulations
provisionally dated November 1, 2006. It thus
appears likely that brokers may be able to offer
margin as early as the end of this year, probably
starting by lending cash rather than stock.
The State Council document cites the need
to "provide a legal channel for bank funds to
enter the market", thus tacitly admitting the
existence of the illegal channels that have often
played a major role in financing stock purchases
in China. In 2001, for example, one estimate put
total illegal bank funds in the market at over
half the total A-share free float at that time. A
typical scheme uncovered in that year involved
branch managers in the northeastern city of
Shenyang who colluded with speculators applying
for 510 million yuan (about US$64 million) in
short-term credit using phony trade invoices.
The PBoC launched two major crackdowns on
such practices, in May 1997 and July 2001. In both
cases, the markets fell sharply on the news, a
good indication of the seriousness of the problem.
The Shanghai composite index fell by 20% from May
20 to July 8, 1997, and 27% from July 26 to
October 22, 2001, as bank and enterprise managers
scrambled to get funds out of the market before
their illegal trading was brought to light.
Probably only a small number of the
largest brokerages (eg CITIC Securities and
Shenyin Wanguo) will initially be able to offer
legal margin facilities as most of their smaller
competitors are unlikely to have sufficient
capital or adequate risk-management systems to
engage in this somewhat risky activity. Those
lucky enough to make the grade can be expected to
enjoy large increases in market share - as the
only players able to finance stock trades, they
will have a strong competitive advantage, and
margin lending by its nature generates high
trading volumes. As it is generally more lucrative
than most other brokering businesses, it should
also lead to big improvements in profitability.
A new warrant bubble The seven
warrants listed so far are the first to come out
since 1996. Like the warrants issued in the early
1990s, they were introduced primarily as a way of
converting the state's unlisted holdings into
tradable stock, rather than to raise capital for
the listed companies. And as was the case 10 years
ago, trading has been driven primarily by
technical features of the warrants themselves,
with the result that warrant-price movements have
had little relation to changes in the underlying
share prices.
Unlike shares, warrants are
settled on a "T+0" basis, which allows speculators
to buy and sell them multiple times on the same
day. This feature has led to very high trading
volumes as traders can execute transactions far in
excess of their capital - as long as they sell
before the end of the day, they are only liable
for the profit or loss on the day's trading. As a
result, there have even been days on which warrant
trading has exceeded the total turnover for all
822 actively traded Shanghai A shares combined.
Not surprisingly, a huge speculative
bubble developed in the warrants as soon as they
were introduced. As occurred in the 1990s, warrant
prices shot up to levels far in excess of their
theoretical values, with call and put prices
(which normally move in opposite directions) often
even moving up or down at the same time.
To bring the situation under control, the
Chinese stock exchanges allowed the brokerages to
flood the markets with new copycat warrants. These
have the same terms as their original counterparts
but differ from them in being issued by securities
companies rather than the state shareholders of
listed companies. In the case of calls, another
difference is that they are backed by existing
tradable stock rather than converted state-owned
shares.
While such broker-issued covered
warrants are quite common in other markets, the
Chinese regulators were widely criticized for
allowing two highly unconventional practices.
First, the covered warrants were listed
with the exact same names and stock codes as the
original warrants. Many saw this as unfair to the
original warrant holders, with some even
suggesting that they should sue the exchanges for
damages to their property rights. (Warrant prices
declined sharply because of the new supply.)
Regardless of the merits of any such case, the two
types of warrant clearly should have been
differentiated from one another, as they obviously
expose the holder to quite different default
risks.
Second, after the listing of
covered put warrants on Wuhan Iron and Steel, it
was discovered that more had been issued than
could possibly be exercised given the size of the
stock's existing free float. According to an
article on the website of the Shanghai Securities
Journal (www.cnstock.com) dated last December 7,
only 1.239 billion shares were circulating (after
the withdrawal of 1.131 billion shares to cover a
call that had also been issued on the stock),
while 1.567 billion puts had been sold. In the
event that the share price finished below the
exercise price, the rights conveyed by 328 million
puts would be worthless because there would not be
enough stock available for the holders to sell.
(Each put conveys the right to sell one share.)
Thus the recent experience with warrants
has been plagued by regulatory missteps. In the
absence of a market maker system, allowing T+0
settlement practically guaranteed that trading
would be wildly speculative. And allowing
indiscriminate sales of covered warrants created a
problem not seen in China since the 327 incident -
derivatives trading without regard for the
available supply of the underlying securities that
would be required for physical settlement.
Unsustainable
pressures Introducing new sources of
leverage into the financial system is a bit like
turbocharging a car. By pumping extra air into the
cylinders, turbocharging makes it possible to
improve performance greatly. But simply installing
the turbocharger without making other necessary
engine modifications would result in unsustainable
pressures building up, eventually blowing the head
gasket and seriously damaging the engine.
Similarly, the history of China's
financial markets over the past 15 years provides
many examples of the unsustainable pressures that
can result from introducing leverage into a
financial system not yet ready to handle it.
Because of administrative and structural problems,
the mechanisms that normally keep derivative
prices in line with those of their underlying
securities have generally failed to operate,
resulting in speculative bubbles. Similarly,
illegal flows of margin financing have resulted in
excessive risk taking because the restraint that
lenders ordinarily impose on speculators through
forced sales cannot be exercised when the true
purpose of the financing is hidden.
For
the current round of financial innovations to lead
to anything more than a repetition of previous
speculative booms and busts, the pressures
generated by new sources of leverage will have to
be contained through strengthened supervision by
the Chinese regulators and improved internal
controls at the financial institutions, along with
the creation of new capabilities for novel
businesses such as stock lending. Given the
continued presence of serious moral-hazard
problems, however, it will be difficult to achieve
all of this at the pace at which the new products
are expected to be introduced.
Unfortunately, it will probably be a long
time before the new turbocharged system can
operate at peak efficiency.
Mark A
DeWeaver, PhD, worked as a research analyst in
Shenzhen from 1991-95, first for W I Carr and
later for Peregrine Brokerage. He manages
Quantrarian Asia Hedge (www.quantrarian.com), a
fund that invests in Asian equities, and can be
reached at deweaver@quantrarian.com
