China's Derivative Market "Great Leap Forward"

By Tian Yun
Published: 2010-10-28

Issue 491, October 25, 2010
Translated by Ruoji Tang
Original article:

The Economic Observer has learned that the China Banking Regulatory Commission (CBRC) has finished drafting “Administrative Rules Governing Derivatives Trading among Banks and Financial Institutions,” (hereon referred to as “new rules”) an update of the 2004 “Provisional Administrative Rules Governing Derivative Activities of Financial Institutions,” which will be released in the coming days.

The 2010 “new rules” will classify derivatives and distribute licenses based on the trading goals and the qualifications of banks and financial institutions. The “new rules” are expected to broaden participation in the derivatives market and will permit institutions to trade credit and commodity derivatives as well as encourage market-making activities.

China’s derivatives market is still relatively small, and depends on contract buys from foreign institutions. During the financial crisis, the CBRC tightened regulations even further, but experts expect the “new rules” to encourage rapid growth and development of the derivatives market.

Preparing for Reform

In 2009, the CBRC issued policies to regulate the operation of the financial derivative trade, stopped Chinese banks from doing “back to back” business with foreign institutions and began drafting new regulations for the derivatives market.

After reviewing relevant propositions in the July 2010 US financial reform bill, and deliberating with experts, the CBRC proposed the “Administrative Rules Governing Derivatives Trading among Banks and Financial Institutions,” introducing key differences from the 2004 “rules.”

The “new rules” will divide derivatives into “base-type” derivatives and “non base-type” derivatives. Base-type derivatives will include, interest rates (including bonds), exchange rates, gold, and silver.  Non base-type derivatives will include commodity, credit (bond credit, loan credit), energy, stock equities, and others.

Banks will receive trading licenses based on the division of derivatives; institutions with advanced licenses, “self-trading” institutions, will be able to trade all derivatives.

An executive from a state-owned investment bank says that in comparison to current regulations, the new rules will broaden the range of the derivatives market. “Right now, the derivatives market is limited to interest rates. Trading ‘non base-type’ derivatives such as credit, commodity, and equity is not permitted.”

Under the old regulations, Chinese banks cannot trade OTC derivatives with Goldman Sachs, Morgan Stanley and other international investment banks. Furthermore, only a handful of domestic banks currently participate in the key CDS market and other important derivatives markets.

According to CBRC figures for 2009, the trading volume on the domestic derivatives market reached 461.64 billion yuan in interest rates, 655.64 billion yuan in long-term bonds, and 801.8 billion US dollars in foreign exchange. But the trading volume of OTC derivatives was less than 10,000 US dollars. The total trading volume for derivatives world-wide was around 600 trillion US dollars. China’s trading volume accounts for less than 1/600. 

“China’s derivatives market is disproportionately small, considering the size of its economy,” said China Securities Regulatory Commission (CSRC) Chairman Jiang Yang. China’s interest rate derivatives trading volume accounts for only 1/10,000 of the world market, and China’s foreign exchange derivatives trading volume and GDP ratio is only ? that of India.

Last week, in a public meeting in Beijing, the CBRC Supervisory Cooperation Department for Banking Innovation Director Li Fuan stated that the regulatory commission had already reached a consensus on reforms for the derivatives market and will open the derivatives market up to increased and broadened participation.

“China is currently in the midst of exchange rate and interest rate adjustments, and taking into account the fluctuation in the US Dollar and the Euro, Chinese banks and enterprises need to hedge risks; also, rapid development of the bond market, a steadier income growth rate and the economic basis for developing the derivatives market is already in place.” said Li Fuan.

The New Licenses

The CBRC is also changing its regulations for banks and financial institutions in the derivatives market.

Banks and Financial enterprises will have to re-apply for different types of licenses; the regulatory commission will implement new guidelines for customer services and the design and sales of financial products.

According to the new plan, the CBRC will divide the derivative products of financial institutions according to their trade purposes. The categories will be “risk management,” “customer service,” “market-making,” and “self-trading.” Institutions dealing in risk management will be subject to hedge accounting requirements.

The broad range of the new licenses has attracted the attention of domestic banks. The new plan will increase the management capacity of the regulatory commission by dividing the licenses into the categories of base, ordinary, and advanced.

Base licenses will be less tightly regulated than under the current plan, and will permit more institutions to enter the derivatives market to hedge assets, but trading will only be permitted on “base-type” derivatives.

Ordinary licenses will have higher requirements and more privileges, but institutions will not be able to engage in proprietary trading.

The advanced license has attracted considerable attention.  It has strict requirements, but institutions will be permitted to engage in proprietary trading and other transactions. But proprietary trading will be limited to “base-type” derivatives.

Banks are expected to compete for the new licenses. The 2004 plan gave banks six months to acquire a license. Banks that did not qualify for a license on time had to cease all derivative-trading activity. At the time, many foreign banks, including Deutsche Bank, found themselves in a do or die situation.

This time, the rush for licenses is expected to have a huge impact on banks. “A lot of business is up in the air, if you qualify for the licenses, there will be a lot of choice and room for development whether you are hedging or reallocating assets,” said Shen Hongpu, from Cinda Asset Management Company’s research center for risk management.

Facing pressures to restructure or develop, new derivatives licenses can give a number of banks the tools they need to neutralize the competition.

The vice president of a commercial bank says they have already begun preparations for the new license.

“These are new profit margins,” said an official from the financial department of a large bank. Even though the advanced license presents new trading risks, banks are still eager to acquire it.  

Foreign investment banks experienced in trading derivatives have a significant advantage in the competition for advanced licenses. The new plan expects the experience of foreign banks to help raise the trading standards of domestic banks.

In addition, the content of the new plan encourages the development of the domestic market making power in the derivatives market. Foreign investment institutions have been the market makers of the domestic derivatives market for a long time because Chinese institutions have lacked the strength. Establishing Chinese market-making institutions and establishing the renminbi in the derivatives market will be crucial for internationalizing the currency and increasing its price-setting power.

Qualitative and Quantitative Impact

“The new plan will be a key moment in the development of China’s derivatives market,” said Jeff Huang, vice president for Asia at the Chicago Climate Exchange.

An authority says that once established the new plan will bring a period of rapid growth for the derivatives market “for at least three years”.

Market expectations for the impact of the new plan are high. Shen Hongpu thinks that the derivatives market will grow tenfold within the medium term.

“The policy changes will cause a large-scale bottleneck in the derivatives market.” ICBC insiders believe that if regulations are loosened, the market will grow. ICBC is preparing to increase its financial department personnel to 2000 and there are plans for a new building.

But the bank has also believes that because risks are high and their experience is limited, any large-scale participation will be carried out slowly.

Reforms are only one aspect, we have to wait and see whether the derivatives market will experience deep structural changes. 

“The reformed derivative market will be divided into two parts: one is the capital market, the other is the risk management and price recovery. China’s capital market is underdeveloped, and smaller than its risk management and price recovery market; there are also structural deficiencies,” says Jeff Huang. Under the new plan, the market for risk management will be effectively regulated, and the other markets will experience growth.

Huang goes on to say, “When the different levels of the financial market are more developed, when there are more financial instruments available, when institutions, enterprises, and investors are able to effectively hedge risks, the financial market will bring significant benefits to the real economy.”

This article was edited by Rose Scobie