Six of one, half a dozen of the other
The mainland authorities' recent approval of margin trading, short selling and stock index futures contracts is bound to reignite the age-old argument over whether these financial innovations, and index futures especially, heighten or reduce volatility in the underlying equity markets.
Judging solely from the reception given to the State Council's January 8 announcement, you would have little doubt that the introduction of the new trading tools would be a positive step for mainland market development.
Supporters of the innovations make a powerful case in their favour. Margin trading - leveraging up the size of your positions with money borrowed from your broker - will improve stock market liquidity, which in turn will improve the overall efficiency of the market.
At the same time, short selling will allow investors to adopt new strategies, encouraging more players to enter the market. Bearish investors will be able to implement their views for the first time by selling stocks short. Meanwhile, value-driven investors will be able to play, anticipating convergence between individual shares while eliminating overall market risk.
For example, in the car sector, they could sell short a stock perceived as overvalued, like BYD, offsetting the exposure by going long shares in a company seen as relatively underpriced, like Denway Motors.
Similarly, for the first time, they will be able directly to arbitrage the price differentials between mainland-listed A shares and Hong Kong-listed H shares, in theory helping to prevent some of the price overshoots and distortions that characterise the mainland market.
But the most prized innovation will be the introduction, probably in the second quarter, of futures trading on the mainland's blue-chip CSI 300 Index.
Futures trading, say the enthusiasts, gives investors a quick, easy and cheap way to hedge their market exposure without selling their underlying holdings of stocks. As a result, it not only improves liquidity and efficiency; it reduces overall market volatility.
That, at least, is the line peddled by the new contracts' supporters. Clearly, China's regulators have their reservations. The China Financial Futures Exchange has been ready to launch trading since late 2006, but the regulators withheld approval for over three years, worried that its contracts could distort trading in the underlying stock market. And when they did finally give the go-ahead, they qualified their approval with barriers to entry designed to keep retail investors out of the market and suppress volatility.
Although it is hard to imagine that the mainland stock market could be even more volatile than it is already (see the first chart below), China's regulators are not alone in their concerns.
Sceptics argue that a stock index futures contract, like margin trading and short selling, will merely make it easier and cheaper for pure speculators to jump into the market.
And because futures are themselves leveraged, the new contract will make it simpler for speculative traders to put on bigger positions, exacerbating movements in the underlying stocks.
Unfortunately, the experience of stock markets elsewhere is no great help in settling the debate about whether the introduction of futures increases or dampens underlying stock market volatility.
Studies in developed markets are inconclusive, splitting more or less equally between those that conclude futures exacerbate stock price movements and those that show a moderation in price swings. For example, one 1990 study argued that the May 1984 introduction of index futures trading in Hong Kong had no impact, while research conducted in 1992 came to the conclusion that futures trading added to volatility in underlying Hang Seng Index stocks.
Often, the objectivity of the research is questionable. One United States study concludes that 'market volatility in the S&P 500 was greater in 1973-82, before futures trading began, than it was in the 1982-86 post-futures period'.
You have to wonder, however, whether the conclusion would have been the same had the authors extended the study to include 1987, the year of the Black Monday stock market crash, in which index futures trading was widely blamed for amplifying the magnitude of the sell-off.
As a result, perhaps the best guide to the impact of futures trading comes not from stock markets but from markets in commodities. Studies of the crude oil market show that although short-term price movements may have been more extreme since the introduction of futures contracts, with futures trading, prices are able to adjust more quickly.
So for example, whereas the crude price increase after Iraq's 1990 invasion of Kuwait was roughly the same order of magnitude as that following the Iranian revolution a decade earlier, the surge following the invasion of Kuwait was much shorter-lived, partly thanks to the impact of futures trading (see the second chart below).
This is more or less the effect we can expect to see in the mainland equity market. Futures trading may well exaggerate short-term price swings, but over the longer term, futures should help the market adjust more easily to new information, moderating, if not wholly eliminating, some of the more persistent price distortions that have plagued the market in recent years.