Ｔｕｒｂｏｃｈａｒｇｉｎｇ　ｔｈｅ　Ｆｉｎａｎｃｉａｌ　Ｍａｒｋｅｔｓ the shy

　　Introduction of new financial instruments may not putChina’s markets in the fast lane just yet, a market analyst warns
　　China has introduced new sources of leverage into the financial system, which will enable participants to have “new opportunities both to hedge their bets and lever them up using futures, options and margin trading,” according to Mark A DeWeaver, a research analyst in Shenzhen who now manages a fund investing in Asian equities called Quantrarian Asia Hedge. He compares these measures to “turbocharging a car,” which he says can damage it if the engine’s basic structure cannot handle the pressure. His main ideas follow:
　　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, 10 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 preset 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 to 1995 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.
　　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.
　　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 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. 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 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 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 in short-term credit using phony trade invoices.
　　The central bank 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 percent from May 20 to July 8, 1997, and 27 percent 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 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 10 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 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 allow 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. Not surprisingly, a huge speculative bubble developed in the warrants as soon as they were introduced.
　　
　　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 Chinese regulators and improved internal controls at 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. n
　　(This article previously appeared in Asia Times Online and is used with the author’s permission. Copyright 2006 Mark A DeWeaver.)

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