A combination of increased global economic uncertainty and ongoing liberalization of its financial markets looks set to accelerate the development of China’s derivatives industry.
The heightened uncertainty caused by the COVID-19 pandemic is moving risk management up the corporate agenda, increasing domestic demand for both existing and new derivatives products. At the same time, rising levels of foreign investment in China have also created an increased need for using futures and options, further driving the development of the derivatives market.
The Growth of Derivatives
Derivatives are still a relatively new product in China compared with Western markets. The first futures exchange was approved in China in 1990, and since then the number of different products available has been gradually expanding, with new products continuing to be launched.
Today, China has five domestic derivatives exchanges offering futures and options on agriculture, energy, metals, chemicals, equities and bonds. Trading volumes have been on an upward trajectory in recent years, as domestic investors become more familiar with futures and options, and demand from foreign investors increases.
More Risk Management Needs
Derivatives play an important role in helping individuals and businesses manage risk and hedge against future adverse movements in the price of a commodity or financial product by enabling them to lock into a pre-set price at a stated future date.
The impact of COVID-19 has led to significant volatility in both asset prices and foreign exchange, increasing the need for risk management programs.
At the same time, futures and options also help to boost liquidity and financial market efficiency because they can be more cost-effective than purchasing an asset outright, leading to higher trading volumes and lower transaction costs.
Rising Domestic Demand
The use of derivatives in China may increase over the longer term as both the product itself and the role it plays in risk management becomes better understood. This trend could be accelerated by the volatility in global commodity and energy prices, as it may increase the take up of risk-mitigation tools among corporates.
Domestic demand for derivatives is also likely to be driven by regulatory changes. Since April 2020, the China Securities Regulatory Commission (CSRC) has allowed China’s five largest state-owned commercial banks and a number of insurers to trade in domestic bond futures as part of a pilot scheme that could lead to the market being opened up to a large number of institutional investors.
Growing Foreign Demand
Demand for futures and options from foreign investors is also increasing as China continues to open up its financial markets. Foreign investors can invest in the A-shares market through the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs, as well as through the Shanghai-Hong Kong, Shenzhen-Hong Kong and Shanghai-London stock connect programs.
The CSRC expanded QFII to include financial futures, commodities futures and options for the first time in January 2019. The move was followed in April 2019 by the China Financial Futures Exchange relaxing trading rules for index futures, including reducing margin requirements and fees, and allowing more trading activities, to help meet the needs of foreign investors.
Some market watchers believe a shortage of tools for managing risk has acted as a brake on China’s inclusion in global indexes. For example, FTSE Russell decided not to include China in its FTSE World Government Bond Index in 2019 due to limited access to derivative products. As China continues to open up its financial markets to foreign investors, its derivatives market also needs to expand to meet these investors’ diversification and hedging needs.
Looking Forward
China has already started to reopen following lockdown measures to limit the spread of COVID-19, and its economy is showing strong signs of rebounding. As economic activity continues to normalize, futures and options can play a role as investors and corporations look to protect themselves from global price volatility.
At the same time, the People’s Bank of China has stressed that the COVID-19 pandemic will not impact policies to continue to open up the country’s financial markets. In fact, in January 2020, foreign ownership caps on futures firms were scrapped, followed by an end to the caps on foreign brokerages and mutual fund managers in April, a year ahead of schedule. In May, investment quotas on the QFII and RQFII were also removed.
All of these factors look set to drive further expansion and evolution of China’s derivatives markets.
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