The real future is in Chinese futures

Through train scheme has diverted attention from derivatives offering broader opportunities

PUBLISHED : Thursday, 31 July, 2014, 3:30pm
UPDATED : Friday, 01 August, 2014, 1:14am

The "through train" that will link the stock exchanges of Hong Kong and Shanghai has become a focus of financial markets in both cities since its announcement in April.

While it is clearly a significant development, several questions remain unanswered.

How quickly will the system be in place? What quotas will be available? How can transaction certainty be achieved? How will the structural differences in settlement models between the two cities be resolved and managed?

The bigger issue is that the Hong Kong-Shanghai Stock Connect scheme has diverted attention from parallel developments in derivatives.

The Shanghai Gold Exchange - a spot and forward market - and the Shanghai Futures Exchange plan to launch new international markets in the Shanghai Free-Trade Zone for precious metals and energy, respectively.

The reality is that the FTZ is one of the core pilot experiments … to open China’s capital markets

Exchange-traded options are also due to go live later this year, and over-the-counter clearing is being introduced across a wide range of asset classes. Anticipated transaction volumes are likely to dwarf those of the through train and the underlying cash markets.

While the trade zone initiatives have been derided by many as hot air, the reality is that it is one of the core pilot experiments of the new leadership to open China's capital markets.

It officially has two years left to prove itself, and billions of yuan already cross the zone's border each month - even at this early stage.

Announced exchange initiatives will be followed by further developments in commodities and currencies.

They are central to policy goals to increase the breadth and depth of derivative instruments, which will facilitate the risk hedging required as price controls are lifted and volatility rises, as well as establish the mainland as the focus of Asian and global pricing power in commodities and other asset classes.

Much work remains to be done to make mainland markets attractive to global investors. Margin structures, for example, are extremely capital intensive. Significant transformation of the derivatives markets, however, will occur in the coming 12 to 24 months. At a time when investors are scraping the barrel for investment ideas and brokerage commission pickings get thinner by the day, these developments present unparalleled opportunities for boosting trading and brokerage services income.

This is crucial, because mainland exchanges clearly would prefer to access global liquidity directly rather than through partnerships with other exchanges.

To do so will require the development of ancillary services, such as risk management, clearing and settlement - functions made all the more complex by cross-border legal issues and the need for collateral to back market exposures.

This is where international financial market specialists operating in Hong Kong have a real competitive advantage and thus a real chance of securing a slice of a mainland derivatives business that will eventually eclipse all market developments to date, including that of the still-to-arrive through train.

William Barkshire is managing director of Agora Partners Limited