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Is China Ready to Establish the Stock Index Futures Market?

By Shiyun Zhang

            I. Introduction

           As a derivative financial product, Stock Index Futures (SIF) is distinguished because of its function in risk management when used duly.

China

is eager to introduce SIF to offer downside protection to investors, stabilize its stock market, and counteract the impact of offshore SIF based on its stock market. This article argues that this desire, however, may be hampered by the immaturity and design defects of the Chinese stock market, the high risk associated with the leverage effect of SIF, and

China

?s incompetence in the advanced financial market compared to sophisticated international investors.

            A SIF contract is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying stock index at a future date at a price agreed on today. [1] The stock index could be understood as a portfolio of stocks characterized by the index. The most commonly-used SIF contract  is the one on the S&P 500 Index introduced by the Chicago Mercantile Exchange (CME). [2] This futures contract contains an implicit multiplier of $250. [3] If a SIF contract is quoted at a price of 1200, the actual futures price is the product of the index and multiplier, or $300,000 (1,200 x 250). All SIF contracts are cash-settled, as the delivery of stock index is impractical. [4] For instance, if the stock index rises from 1200 to 1210, the seller should pay the buyer $2500 in cash [(1210 ? 1200) x 250]; similarly, if the stock index drops to 1190, then the buyer should pay seller $2500. The seller gains when futures prices decrease and loses when futures prices increase.  The outcome is the opposite for the buyer. [5]

            In the modern view, the most important function of SIF is risk management. [6] Assuming one week later a funds manager will cash part of his stock portfolio which tracks the stock index, his present judgment is that the stock index will go up, but he is also concerned that it will fall because of some uncertainties. Under this situation, he could hedge against the downward risk by entering a selling position in the SIF market. If the stock index really goes down, his gains in the SIF market will compensate for his losses in the stock market. If the stock index goes up, then his gains in the stock market could compensate for his losses in the SIF market. Thus as long as the manager makes use of the SIF duly, he could keep the risk at his desired level. In addition to the function of risk management, SIF also has merits in price discovery, the low transaction cost, the improvement of the efficiency of stock market, [7] and increasing investors? exposure to the overall stock market. [8]

            The SIF made its debut in Kansas City Board of Trade on

February 24, 1982

. [9] Two months later, CME advanced the most successful SIF on S&P 500. [10] Nowadays, almost every developed country has a SIF contract based on the leading equities of that country. [11] The global market for exchange-traded SIF was notionally valued by the Bank for International Settlements at $221,200 million in 2005. [12]

            II. The Preparation Work for Chinese SIF Market

           The Chinese stock market has soared in the past a few years. The Shanghai Composite Index was 998.23 on

June 6, 2005

, and then climbed to 6124.04 on

October 16, 2007

. The Shenzhen Component Index was 2729.198 on

June 6, 2005

, and rose to 19,531.155 on

October 31, 2007

. Thus, the

Shanghai

and Shenzhen stock markets increased by more than five and six times, respectively, in twenty-eight months. With the prosperity of the stock market,

China

is eager for financial innovations and would like to introduce a new derivative product -- SIF. [13]

            Two additional factors also factor into

China

?s determination to establish its SIF market. First, unlike developed countries, short sales, which are ?the sale of stock that one does not own with the intent of purchasing back later at a lower price?, [14] are entirely prohibited in the Chinese stock market. [15] Therefore, investors could earn money only when stock prices rise; once they go down, investors lose money. As a result, investors tend to push the stock index up until it cannot maintain any longer at the high price, and then the index plunges to the bottom. In this context, it becomes especially necessary for

China

to introduce SIF because it offers downside protection to investors and could stabilize the stock market.

            Second,

China

was stimulated by Singapore Exchange Ltd. (SGX) to speed up the establishment of the domestic SIF market. Based on the Chinese stock market, SGX presented FTSE Xinhua China A50 Index futures on

September 5, 2006

. [16] The SIF trading in SGX would not only detract

China

?s financial resource, [17] but also affect Chinese stock indexes significantly. [18] Furthermore,

China

has no authority to supervise those transactions, even though some of them may be illegal, as SGX is foreign institution and those transactions occur overseas. [19] Naturally,

China

would like to have its own SIF market, hence reducing the adverse effects caused by FTSE Xinhua China A50 Index futures.

            So far,

China

has already made many preparations for the inauguration of SIF. HuShen 300 Index was published in April, 2005, which consisted of 300 representative stocks selected from the Shanghai Stock Exchange and the Shenzhen Stock Exchange. [20] On

September 8, 2006

, China Financial Futures Exchange came into existence in

Shanghai

. [21] On

October 30^th, 2006

, the simulation transaction on HuShen 300 Index started. [22] On

March 16, 2007

, Regulation on the Administration of Futures Trading was promulgated by China State Council and came into force as of

April 15, 2007

. [23] From then on, many rules, orders, and bylaws were enacted. The preliminary supervision network was thereafter formed. ?
            III. Is

China

Ready to Begin the SIF Market?

            The Chinese economy booms, stock market soars, and many preparations have been done for the SIF transactions, but are they solid enough for

China

to initiate its SIF market? Despite the benefits of SIF discussed above, what are the risks associated with this investment instrument? These questions further lead to a key question: is now the right time for

China

to establish its SIF market? Several issues that hamper Chinese SIF market are discussed in the following.

            1. The immaturity of the Chinese stock market constitutes an unavoidable barrier for

China

to establish efficient SIF market.

            Futures returns derive from the returns of underlying assets. [24] Therefore, the performance of the SIF market is based on the performance of the underlying stock market. [25] The underlying stock market must be efficient. It ?refers to the informational efficiency of markets?. [26] That is, ?security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security?. [27] The Strong-form Efficient Market Hypothesis assumes ?nobody has private information, so no group should be able to derive above-average returns consistently?, [28] Although studies do not support this hypothesis because corporate insiders and stock exchange specialists ?apparently have monopolistic access to important information and use it to derive above-average returns.? [29] For this reason,

U.S.

securities law saves no efforts on underlining the disclosure of material information. Though illegal actions exist in the

US

stock market, they are generally limited in scope due to the supervision of Securities and Exchange Commission.

            When it comes to the Chinese stock market, its prosperity can never cover its inequality, incompliance, and irregularity. ?There is plenty of useful information for speculators (insider activity, government intervention, fraud, sudden regulatory changes, etc.)?, [30] so Jinlian Wu, one of the most respected Chinese economists criticized the Chinese stock market fiercely. He pointed out that the Chinese stock market is more unfair than gambling because in the Chinese stock market, someone could see others? cards, cheat, and deceive. [31] Thus, market manipulation is unparalleled. [32]         

            The poor design is the source of the Chinese stock market?s disorders. Due to complex ideological, political, historical, and economic factors at play during the design of the Chinese stock market, the authority divided the shares into two classes.  The majority was delegated to state designated administrative persons at very low prices, while the remaining minority class was sold to the public at much higher prices. [33] Taking the stock ?Zijin Mining? as an extreme example, the price for the former class was only RMB ¥0.1 per share, while the latter RMB ¥7.13. Although these two classes of shares have obviously different prices, they own the same right in every aspect. [34] So from the very beginning, the controllers of the former class (not shareholders, since nominally these shares belong to all people) already captured huge wealth from the latter. [35] Moreover, this design provided the former with incomparable advantage, convenience, and even incentive to manipulate the market. [36] Many exchange-traded corporations only view the stock market as a place to collect money without or with little cost. [37] Accordingly, the commoners only view the stock market as a place to speculate. [38] Even though

China

has been addressing this problem over the recent years, the overall situation has not changed as of yet. [39]

            The weak supervision is another imputable reason. In Chin a, the law and regulations are too simple and ambiguous to enforce. [40] For instance, the securities law merely states briefly that the information should be complete, accurate, and true, and it is against the law to reveal information illegally.

China

also lacks the database and instruments necessary for the supervisory authority, China Securities Regulatory Commission (CSRC), to assume its responsibility. [41] Consequently, CSRC often responds slowly and clumsily to suspicious stock transactions.

            When insider trading, market manipulation, and rumors are prevailing in the Chinese stock market, the price of stock index may have nothing to do with the performance of corporations. As a result, the forecast of stock index becomes meaningless since it is unpredictable. If so, how could the market be efficient? How could the SIF transactions proceed, as they require the judgment of future stock index tendency? Moreover, would Chinese SIF market only prove to be an even larger gambling compared to the Chinese stock market?

            2. The high risk magnified by the leverage effect of SIF requires

China

to prepare better before it inaugurates the SIF market.

            To ensure the fulfillment of futures contract, a mechanism known as clearinghouse is adopted. [42] Before transactions begin, both the buyer and seller must deposit an amount of money called margin at the clearinghouse. [43] Thereafter, the gains and losses on each party?s positions are credited and charged to the margin on a daily basis. [44] Given an oversimplified example here, assuming the initial margin requirement set by the clearinghouse is $25,000 and the beginning price for the stock index is quoted at 1000 (actual price $250,000), both parties need to deposit $25,000 per contract at the clearinghouse. If the stock index rises to 1010, the buyer will gain $2500 [(1,010-1,000) x $250], and the seller will lose $2500 per contract. If the stock index soars to 1110, the buyer will gain $27,500 and the seller will lose $27,500 per contract. On the other hand, if the stock index price falls, the seller will gain money at the expense of buyer. The clearinghouse collects and disburses the margin money every day, sometime several times a day.

            From the above example, we find: (a) margin requirement ($25,000) is much smaller than the futures price ($250,000). ?In fact, futures margins are usually less than 10 percent of the futures price?. [45] (b) Parties can lose money ($27,500) more than they have deposited in the margin ($25,000). The total amount of money buyer could lose is limited to the futures price $250,000, as the stock index falls to zero. [46] In another word, if the initial margin requirement is 10 percent of the futures price, the potential losses are 10 times of the margin for the buyer. For the seller, ?there is no upper limit on the (futures) price and the potential loss is theoretically infinite?. [47] (c) Because buyer and seller are in the opposite positions, the buyer?s potential gains are infinite, and the seller?s potential gains are limited to the futures price. Therefore, by putting up a small amount of money, the parties? gains or losses are multiplied significantly due to the leverage effect of the futures market.

            In addition to the leverage effect, the complexity of SIF also attributes to the high risk of SIF. [48] Sometimes the parties using this instrument actually do not understand it well. When they use it unduly, they may suffer from huge losses. For these reasons,

China

may need more time to get ready to introduce SIF.

            3. It is uncertain weather

China

has the capacity to play with sophisticated international investors and deal with malicious speculation. 

            One feature of the financial market is that it is a continuous global market. Considering the huge profit potentials and their own sophistication in futures market, no international investors will miss the opportunities in Chinese upcoming SIF market, not to mention the fact that another design defect in the Chinese stock market gives international investors advantage. ?International financial giants have reportedly been lobbying Chinese regulators to let them join the first batch of investors to trade the nation's pioneering SIF?. [49] It is widely believed that international investors are much more ready than Chinese. [50] Moreover, they may take advantage of the weak supervision of the Chinese security market, engaging in malicious speculations through illegal methods. [51]

            As introduced above, one class of Chinese stock shares was sold to the public. Actually it was further divided into subclasses. ?A? shares were sold to mainland Chinese, while ?B? shares were solely sold to international investors and the prices were much cheaper. For this reason, although Michael Pettis opposed the establishment of Chinese SIF market, he admitted it is a great thing for international investors to arbitrage. ?B-shares are so cheap relative to their A-share equivalents (more than 30% discount) that it makes sense for foreign investors to buy B-shares and short the index. Of course there will be tons of tracking error, but with a 50% return to convergence, what's a little tracking error?? [52]

            Some international investors? intention to manipulate stock index also causes concerns. It is said that some international investors are purchasing Chinese middle-cap corporations? stocks at large scale, which have significant influence on the stock index. [53] The methods they use are very covert, including dispersing transactions all over different exchanges, trading under many commoners? name, or trading through many sub-sub-sub-corporations, etc. [54] Those methods are so crafty that even sophisticated experts have difficulty in detecting them. Once

China

begins its SIF market, they could use their shares to manipulate the stock index, thus gaining huge profits, and then withdraw. [55] The consequence is that Chinese SIF market collapses and Chinese security market enters a long term bearish period. [56]

            Because of the complexity of the overall situation,

China

is stuck in a dilemma. It feels the pressure of introducing SIF and expects the benefits brought about by SIF, but it also anticipates the crises which may be caused by SIF. Trying to find a balance point between them,

China

has postponed the inauguration of SIF repeatedly since 2006. [57] Recently, CSRC claimed that there is no time frame to advance Chinese SIF. [58] It may wait for a time when the Chinese stock market reformation makes substantial progress and the Chinese stock market stabilizes after the big fall in the second half of 2008.

[1] 6 Don M. Chance, Futures Markets and Contracts, Derivatives and Alternative Investments 49-50 (2008).

[2]

Id.

at 71.

[3]

Id.

[4]

Id.

[5]

Id.

at 50.

[6] 6 Don M. Chance, Derivative Market and Instruments, Derivatives and Alternative Investements 21 (2008).

[7]

Id.

at 20-22.

[8] 6 Bruno Solnik and Dennis McLeavey, Alternative Investments, Derivatives and Alternative Investments 180 (2008).

[9] Anup Menon, Stock Index Futures: A Snapshot, Hindu Bus. Line,

May 28, 2000

,

http://www.hinduonnet.com/businessline/iw/2000/05/28/stories/0828h012.htm, (last visited

July 24, 2008

)

[10] Chance, supra note 1, at 71.

[11]

Id.

[12] Wikipedia, Stock market index future, http://en.wikipedia.org/wiki/Stock_market_index_future, (last visited

July 24, 2008

)

[13] CRI English, Event Background, CRIENLISH.com,

Sept. 19, 2007

, http://english.cri.cn/3130/2007/09/19/262@275704.htm (last visited

July 25, 2008

)

[14] 5 Frank K. Reilly and Keith C. Brown, Organization and Functioning of Securities Markets, Equity and Fixed Income 25 (2008).

[15] Ye Wang, A Brief Discussion of the Short Selling Mechanism in the Stock Market,

Heilongjiang

Foreign Econ. Rel. & Trade, Aug. 2006, http://scholar.ilib.cn/Abstract.aspx?A=hljdwjm200608041, (last visited

July 25, 2008

)

[16] Shuguang Wei, Limited Transaction of A50 Index Futures on the First Trading Day, Sec. Times,

September 6, 2006

, http://finance.sina.com.cn/stock/y/20060906/07512888670.shtml (last visited

July 25, 2008

)

[17] Tingjun Huang, It Matters That Chinese SIF Is Presented First Overseas, Econ. Info. Daily,

Dec. 2, 2004

, , http://finance.qq.com/a/20041202/000063.htm (last visited

July 24, 2008

)

[18] Xiaodong Yu, A50 Index Futures Affects Chinese ?A? Shares More and More
Dramatically,

Beijing

Morning Post,

Sept. 13, 2007

, http://finance.sina.com.cn/stock/t/20070913/23301665287.shtml (last visited

July 24, 2008

)

[19] Huang, supra note 17.

[20] Xiaohua Liu, Big Events Record of Chinese SIF, China Value Net, Feb. 16, 2008, http://www.chinavalue.net/Article/Archive/2008/2/16/99531.html (last visited July 24, 2008)

[21]

Id.

[22]

Id.

[23]

Id.

[24] Chance, supra note 6, at 8.

[25]

Id.

[26] 5 Cijay Singal, Market Efficiency and Anomalies, Equity and Fixed Income 95 (2008).

[27] 5 Frank K. Reilly and Keith C. Brown, Efficient Capital Markets, Equity and Fixed Income 61 (2008).

[28] Chance, supra note 6, at 21.

[29]

Id.

[30] Michael Pettis, Stock Index Futures, Aug.13, 3007, http://www.piaohaoreport.sampasite.com/china-financial-markets/blog/Stock-index-futures.htm  (last visited

July 24, 2008

).

[31] Jinglian Wu, Does the 10-year The Chinese Stock Market Become Gambling? Sohu Bus.,

Jan. 13-14, 2002

, http://business.sohu.com/78/72/article200607278.shtml (last visited

July 24, 2008

)

[32]

Id.

[33] Wu Chen, Do Not Negate the Stock Market Reformation Only Because of the Market Downturn, Chine Bus. Times,

July 4, 2008

, http://finance.jrj.com.cn/news/2008-07-04/000003810996.html, (last visited

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)

[34] Shuntang Xu, Question the Principle of ?Same Shares, Same Right?, Sina Fin.,

Oct. 18, 2004

, http://finance.sina.com.cn/stock/ychd/20041018/17321087222.shtml, (last visited

July 24, 2008

)

[35]

Id.

[36] Chen, supra note 33.

[37] Xu, supra note 34.

[38] Siwei Cheng, What Are The Problems of The Chinese Stock Market? Econ. Daily,

Sept. 17, 2003

, http://www.sinovc1st.com/articleview/2003-9-17/article_view_802.htm (last visited

July 24, 2008

)

[39] Mingfu Yuan, Stock Market Reformation Tests the Supervision

Authority

,

China

Econ. Times,

Mar. 20, 2008

, http://finance.sina.com.cn/stock/stocktalk/20080320/09024645767.shtml, (last visited

July 24, 2008

)

[40] Cheng, supra note 38.

[41] Tao Feng, The Weak Wupervision of CSRC, Reuters

Jan. 14, 2008

, http://cn.reuters.com/article/columnistNews/idCNChina-477620080114?pageNumber=3&virtualBrandChannel=0 (last visited

July 24, 2008

).

[42] Chance, supra note 1, at 53.

[43]

Id.

at 55.

[44] 

Id.

at 53.

[45]

Id.

at 55.

[46]

Id.

at 58.

[47]

Id.

[48] Chance, supra note 6, at 22.

[49] Statement of Embassy of the People?s Republic of China in the United States of America, China Aims To Launch SIF in 1st Half of 2007, Mar. 5, 2007, http://www.china-embassy.org/eng/gyzg/t301305.htm (last visited July 24, 2008)

[50] Jie Huang, Tao chen, & Shuguang Zhang, Foreign Funds Intend to Attack Chinese SIFMarket, China Bus. Times,

Feb. 24, 2008

,  http://finance.sina.com.cn/money/future/20080224/03424539635.shtml (last visited

July 24, 2008

)

[51]

Id.

[52] Pettis, supra note 30.

[53] Huang, Chen, & Zhang, supra note 50.

[54] Id.

[55] Id.

[56] Id.

[57] Ziwei, The Appropriate Time to Advance SIF, Hexun.com,

May 21, 2008

, http://qizhi.hexun.com/2008-05-21/106130260.html (last visited

July 25, 2008

)

[58] Yang yu, There Is No Time Frame to Advance the SIF Market, Sec. Times,

July 19, 2008

, http://qizhi.hexun.com/2008-07-19/107548225.html (last visited

July 25, 2008

)

Full post as published by The Journal of the Business Law Society on November 23, 2008 (boomark / email).