Chinas Derivatives Market - Research Paper Example

 Table of Contents Title Page 1 Table of Contents 2 I. Background 3 II. Literature Review 4 A. Chinese Yuan Derivatives 4 1. CNY Forwards 4 2. CNY Nondeliverable Forwards (NDFs) 4 3. Chinese Yuan Swaps 5 4. CNY Nondeliverable Options (NDOs) 5 B. Development in the Chinese Derivatives Market 6 C. Chinese Derivative Regulation Compared to International Practices 7 D. Future Development of CNY Derivatives in China 8 III. Research Questions 8 IV Methodology 9 A. Sampling Population 9 B. Sampling Procedure and Size 9 C. Methodology - Philosophy 10 D. Methodology – Design 10 E. Methodology – Proposed Data Analysis 10 F. Methodology – Limitations 11 V Project Plans 12 References 13 Appendix 14 I. Background The use (and abuse) of derivatives has been the center of extreme controversy ever since the US subprime mortgage crash in 2007. Top-rated exotic derivatives were quickly converted into toxic assets, which only points to the sophistication of derivatives and the difficulty of assessing their risks. The absence of derivatives in a modern market is unthinkable, however, because of their necessity in hedging currency and volatility risks, in order to attract investments by institutional funds. . Recent years have seen an acceleration of foreign direct investment and a rise in trade surplus in the Chinese economy. Strong export growth fuelled a trade surplus amounting to US$170 billion in 2006 alone, prompting the flow of hot money into China’s capital markets in anticipation of an appreciation in the renminbi (Menager-Xu, 20. As a result, foreign exchange reserves rose to more than US$1 trillion by the third quarter of 2006, making it the largest foreign exchange reserve held by any country in the world (Qimeng, & Qian, 2007). The phenomenal growth of investments in China’s capital markets have prompted financial institutions to seek increased hedging with renminbi derivatives. This has been met by quick response by regulatory authorities with supporting legislation governing exchange forwards and swaps. While still appreciably distant from meeting international market standards, there are indications that the rules governing constraints on derivatives markets are noticeably changing towards that direction (Qimeng, & Qian, 2007). Hopefully, new laws to clarify key issues in the derivatives and structure products market, such as enforceability of close-out netting and methods of taking collateral are forthcoming (Liew, Soong, & Zhang, 2007). II. Literature review The following is a review of current academic literature on the Chinese derivatives market and its development. A. Chinese Yuan (CNY) Derivatives China’s derivatives market has developed together with the phenomenal growth rate of her economy, as a risk management tool more than a speculative instrument. A discussion of the various financial derivative instruments in the Chinese derivatives market follows: 1. CNY Forwards Acknowledged as the basic foreign exchange hedging, tool, foreign exchange forwards is a widely common offering in all developed markets, as well as countries hardest hit by the Asian financial crisis of 1997. The China Foreign Exchange Trade System (CFETS) commenced with the limited transaction of CNY transactions, largely as an experiment, as of April 1995, one year after the CFETS began forex spot trading in April 1994. With the formulation of tentative guidelines by the PBOC, the Bank of China (BOC), which was then the only bank authorized, began transacting in CNY forwards on April 1, 1997. Presently, all four state-owned banks are permitted to transact CNY forwards businesses (Zhang, 2004). 2 CNY Non-Deliverable Forwards (NDFs) For as long as the domestic currency is not fully convertible, foreign exchange NDF contracts eventually find their way to offshore markets. And even if an emerging market has a domestic foreign exchange forwards market, in order to overcome liquidity problems with this market, a corresponding offshore NDF market will coexist. It is therefore natural for offshore CNY NDFs to flourish, because the CNY is a managed currency floating only within a narrow range, and international participants are unable to access the CNY market. For most international participants, therefore, the CNY NDF market offers the most active offshore trading (Zhang, 2004). 3 Chinese Yuan Swaps Cross-currency swaps (CCSs) are contracts between two counterparties who commit to exchange streams of interest payments in different currencies for an agreed period of time according to an agreed-upon frequency, (e.g. annual, semi-annual or quarterly) and to each restore the principal amounts in their proper currencies at an agreed-up exchange rate upon maturity of the contract. There are variations to these contract, such as the nondeliverable swaps, FX forward swaps and nondeliverable FX forward swaps. (Zhang, 2004). 4 CNY Nondeliverable Options (NDOs) The CNY NDO is the second most popular offshore CNY derivative product, next to CNY NDFs, and originated shortly after the Hong Kong CNY NDFs. Forwards are less sophisticated than options; thus participants in the options markets use several trading strategies in the process of hedging their positions in NDFs, or alternatively directly trade NDOs. Trading volumes of CNY NDOs, however, are usually lower than the corresponding volumes of CNY NDFs, by a factor of about half during periods of low volatility, to about three-quarters during more active markets (Zhang, 2004). Other products such as structured deposits related to CNY, CNY structured notes, onshore products and offshore derivatives shall further be discussed in the course of the study. B. Developments in the Chinese Derivatives Market In 2004, the China Banking Regulatory Commission (CBRC) promulgated the Provisional Administrative Rules Governing the Derivatives Activities of Financial Institutions, more commonly referred to as the “Derivative Rules”. This ushered in a period of rapid growth for the derivative and structure product market. The CBRC imposed regulatory measures to ensure the viable growth of the market, such as the establishment of comprehensive risk management rules, among which are the “know-your-client” and “product suitability” requirements (Liew, Soong, & Zhang, 2007). On August 2, 2005, the People’s Bank of China (PBOC) issued the Notice on Issues Regarding Expanding Designated Banks’ Forward Sale and Purchase of Foreign Exchange Business to Customers and Launching RMB Swaps against Foreign Currencies (PBOC Notice). Prior to the effectivity of this Notice, the license to conduct renminbi forwards was limited to only four large state-owned commercial banks; with the Notice given effect, nearly all commercial banks, including branches of foreign-owned banks operating in China, were allowed to engage in renminbi forward trading (Qimeng, & Qian, 2007). On December 2, 2005, the CBRC’s Notice on the Issues of Business Scope of Derivative Product Transactions by Domestic Commercial Banks (otherwise known as the CBRC Business Scope Notice) lifted prohibitions on domestic commercial banks to engage in derivatives products linked to equities and commodities. Previously, such types of derivative products were banned due to the principle of segregation of the banking sector from the securities and futures sectors as a risk-management safeguard (Qimeng, & Qian, 2007). The effectivity of the Qualified Domestic Institutional Investors (or QDII) scheme commencing April 2006 allowed commercial banks to pool clients’ funds and invest them in offshore financial instruments including structured notes. A year later, in June 2007 the CBRC suspended other remaining restrictions on direct investments by QDII banks in shares and structure products linked to shares (Liew, et al., 2007; Bryan, Yang & Wang, 2008). Aside from commercial banks, other financial institutions have registered growing participation in the Chinese derivatives markets (Liew, et al., 2007). Since September 2007, several fund management companies have been able to obtain their QDII licenses, and at least two QDII-compliant fund products have been successfully launched (Bryan et al., 2008). C. Chinese derivative regulation compared to international practices There are marked differences between the regulation of foreign exchange derivative transactions and the prevailing international market practices. Qimeng and Qian (2007) enumerate these as follows: “[i] non-financial institutions shall only carry out derivatives transactions with hedging purposes and backed by true trade business; “[ii] when engaging in the foreign exchange forward and swap business, banks are required to verify whether the settlement of foreign exchange by the domestic entity complies with the applicable regulations; and “[iii] at the maturity of the forwards and swaps, banks are not able to perform their contractual obligations before they have examined the validity of the documents provided by the domestic entities” (Qimeng, & Qian, 2007, p. 35). There are further safeguards to derivatives trading instituted in China during the advent of the global financial crisis. The study by Bryan, Yang and Wang (2008) have enumerated the restrictions on derivatives trading in the Chinese market that were in place as of September 2007. As of the third quarter of 2007, funds and collective investment schemes were allowed to invest in derivatives products subject to the restrictions as shown in Appendix A. D. Future Development of CNY Derivatives in China Menager-Xu (2007) sees two drivers to future growth: the first motivator lies in the competition in the pricing power for commodities, the second is seen to arise form the need for financial derivatives with which to hedge a stronger flow of hot money investments in the country. China’s desire to attract large institutional players necessitate the introduction of stock index futures and options, and to transform its banking sector, robust interest rate and foreign exchange derivatives markets are a requisite (Menager-Xu, 2007). III. Research questions 1. What is the current state of the Chinese derivatives market, in comparison to international markets, after the financial crisis of 2008? 2. What differences exist between the Chinese regulatory system and those of the developed international markets? 3. What future directions should Chinese legislative and regulatory authorities take in view of the changing scenario brought about by the past financial crisis and the impending economic recovery? IV. Methodology Sampling population The sampling population shall be comprised of managers or securities analysts of financial institutions, investment firms and investment funds which are currently invested in the Chinese equities and currencies market. These groups of individuals are seen to represent the interests of foreign and domestic funds presently positioned in the Chinese investment market, and who are knowledgeable about hedging through derivatives. Individual investors are excluded because due to their comparatively lower volumes, they normally do not require the need to hedge. Only one respondent representing each fund shall be interviewed. Sampling procedure and size There is verifiable evidence that there exist 105 RMB funds (Zero2IPO, 2010) and at least 40 foreign currency denominated funds (Smith & Song, 2006) invested in the Chinese financial markets. It is assumed that the number of 40 foreign funds have not increased, due to the financial crisis of 2007 the effects of which are still felt today. This researcher intends to rank the funds according to their size of investments in the Chinese market. Then I shall interview the top five concerning their impressions of the regulatory framework in the Chinese derivatives market. I shall then proceed lower through the ranks until the point of data saturation is reached, i.e. that point where the researcher no longer hears or sees new information (Siegle, 2010). Methodology – Philosophy The research philosophy to be pursued in this study is that of phenomenology, for the reasons that its basic belief is that the world is socially constructed and subjective, the researcher forms part of the world being observed, the focus shall be on the meanings and totality of the occurrences, and the research design shall be evolving and flexible but mainly employing observation, documentation, and open-ended, semi-structure interviews. Methodology – Design Participant observation and in-depth semi-structured interviewing are considered appropriate to answer the research question, because of the need to obtain detailed explanations concerning the effects of regulation in the market. (Siegle, 2010). Methodology – proposed data analysis The research method shall pursue the “grounded theory” process, and employ the “rich-thick” description to portray a detailed picture of the respondents’ answers. As is appropriate, the research analysis should accommodate the intricacies of the pros and cons of regulation and its various statutes and norms, which is already too controversial a matter to be viewed simply from the point of view of objective positivism. Methodology – limitations As is true with any qualitative research, the limitation to this research is the relative limit in the number of persons to be interviewed and the accessibility of the best possible representative for each institution or fund. The degree to which these individuals could answer with candor and openness is another limitation, as understandly they shall be speaking about methods and strategies that affect their clientele or comprise their industry secrets, and thus will observe a level of secrecy. Finally, since the market for derivatives in the Chinese market has been active only in the past few years, observations will be qualified by the evolving nature of market regulations. Conclusions herein arrived at will need corroboration by another study in the next few years. V. Project plans References Bryan, P D; Yang, T C; & Wang, L 2008 ‘An Update on China’s Derivatives Market’, The Journal of Structured Finance, Winter 2008, pp 49-59 Li, D W P 2008 ‘Is China’s bond market really inefficient?’, Journal of Risk Management in Financial Institutions, vol. 2, no. 2, pp. 141-154 Liew, C-C; Soong, I-P; & Zhang, S 2007 ‘China Derivatives and Structured Products,’ Hong Kong Securities, November/December 2007, pp. 41-44 Menager-Xu, M Y 2007 ‘China’s Derivatives Markets’, in Financial Markets: An Insider’s Guide to How the Markets Work, Neftci, S N & Menager-Xu, M Y, eds., Elsevier, Inc., Burlington, MA Qimeng, H & Qian, J 2007 ‘New Regulatory Developments in China’s Derivatives Markets’, China Law & Practice, Feb 2007, pp. 34-36 Siegle, D 2010 Principles and Methods in Educational Research. The University of Connecticut. Accessed 15 April 2010 Smith, A & Song, X 2006 A Competitive Study on Foreign Fund Utilization in Chinese Insurance Industry and Banking Industry. Asian Development Bank. Accessed 15 April 2010 < www.ccsenet.org/webdocs/SamplePaper.doc> Zero2IPO, 2010 Accessed 15 April 2010 Zhang, P G 2004 Chinese Yuan (Renminbi) Derivative Products, World Scientific Publishing Co., Pte. Ltd., Singapore Appendix A Restrictions in the Trading and Investment in the Chinese Derivative Market Restrictions under which, funds and collective investment schemes were allowed to invest in derivatives products, as of the third quarter of 2007: “They may invest in structured products linked to fixed-income, equity, credit, and commodity indices and funds, and so forth. However, the CSRC does not appear to regard such investments as investments in derivatives. “They may invest in forwards and swaps as well as financial derivatives products listed on a foreign exchange recognized by the CSRC (e.g., CME, CBOT, and others as set out in the appendix to the implementing circular of the CSRC QDII Measures). “They may not directly invest in commodity derivatives. “Investment in derivatives will only be allowed for the purpose of hedging or effective management of investment portfolios. Neither speculative nor leveraged trading will be permitted. “The total exposure of a fund or a collective investment scheme to financial derivatives must not exceed the net assets of the fund or the collective scheme. “The aggregate of the initial margin for investments in futures, the option fees paid or received for investments in options, and the initial cost of investments in OTC derivatives must not be more than 10% of the net assets of the fund or the collective investment scheme.” (Bryan, et al., 2008) Additionally, an over-the-counter (OTC) transaction in financial derivative products by a fund or collective investment scheme will also be subject to the following requisites: “All counterparties except Chinese-funded commercial banks must meet the minimum rating standards set out by the CSRC in the implementing circular. “All counterparties must conduct valuations of their transactions every business day, and the fund or collective investment scheme must be capable of terminating the transaction at any time at a fair price. “The fund's or the collective investment scheme's market value exposure to any single counterparty must not exceed 20% of the net assets of the fund or the collective investment scheme.” (Bryan, et al., 2008) Before a fund or collective investment scheme may invest in derivatives, however, the fund management or securities company must first disclose to the CSRC its risk management procedures and hedging strategies. An annual report to the CSRC is also mandatory, indicating the investing company’s derivatives position and its own risk appraisal and analysis of its derivative position. Read More