OREANDA-NEWS. China financial reforms could best be summed up in the late leader Deng Xiaoping’s words, “crossing a river by feeling the stones”.

On 9 February, Shanghai Stock Exchange launched China’s first financial options, the SSE50 ETF options. The first day saw some 18,843 contracts traded, a smooth debut which did not result in excessive volatility or irrational speculation.  Market reopened after the long Chinese New Year break with 16,856 contracts traded.

The options are based on the Exchange-Trade Fund (ETF) that tracks the SSE50 index, composed of the 50 most heavily weighted stocks on the bourse. The regulator is essentially guiding investors into blue chips, which most retail investors have avoided in favour of smaller firms, whose valuations have soared.

Due to their perceived risky nature, China has taken careful steps, through intensive investor education, strict regulatory policy and trading restrictions to curb risk.  Plans to trade options for individual stocks have yet to be disclosed, a sign that the regulator has adopted a cautious approach.

The launch of options represents a major milestone and innovation in the country's equity markets. Options offer investors more flexible risk coordination tools.  

Market makers and proprietary desks are reportedly using the SSE50 ETF to hedge customers’ options positions. Yet on the other hand, the limitations associated with ETF, such as the costs of borrowing and shorting the ETFs, have also resulted in some firms exploring futures as substitutes.

Last week, CFFEX announced that it would start mock trading of two new products – the SSE50 and CSI500 index futures – on 21st March 2015.

High correlation between the SSE50 and FTSE China A50 Indices

The launch of the SSE50 ETF options is expected to generate more interest in the SGX listed FTSE China A50 Index, given the high correlation between the 2 indices.

The FTSE China A50 index and SSE50 Index shares a total of 30 members. As the GIC sector classification indicates, 67% of components in both indices belong to the financial sector with the industrial segment coming in second with 9.90% for the FTSE China A50 and 12.05% for the SSE50 index. In short, both indices are financials-heavy.

Common Stocks Shared by FTSE China A50 and Shanghai Stock Exchange 50 Index

Agricultural Bank of China Ltd China United Network Communications Ltd
Anhui Conch Cement Co Ltd CITIC Securities Co Ltd
Bank of Beijing Co Ltd CSR Corp Ltd
Bank of Communications Co Ltd Daqin Railway Co Ltd
China CITIC Bank Corp Ltd Haitong Securities Co Ltd
China Everbright Bank Co Ltd Huaxia Bank Co Ltd
China Life Insurance Co Ltd ICBC
China Merchants Bank Co Ltd Industrial Bank Co Ltd
China Merchants Securities Co Ltd Inner Mongolia Yili Industrial Group Co
China Minsheng Banking Corp Ltd Kweichow Moutai Co Ltd
China Pacific Insurance Group Co Ltd PetroChina Co Ltd
China Petroleum & Chemical Corp Ping An Insurance Group Co of China Ltd
China Shenhua Energy Co Ltd SAIC Motor Corp Ltd
China Shipbuilding Industry Co Ltd Shanghai International Port Group Co Ltd
China State Construction Engineering Cor Shanghai Pudong Development Bank Co Ltd

Source: Bloomberg 10 February 2015

Source: Bloomberg 12 February 2015

Trading and Hedging Opportunities with the SGX FTSE China A50 Index Futures

With a total volume of some 120 million contracts in 2014, SGX FTSE China A50 Index Futures stands out as the ideal future instrument with sufficient liquidity and depth to complement the trading and hedging against onshore and offshore cash and derivatives products.

As demonstrated during the recent period of high volatility, the extended trading hours of the SGX FTSE China A50 Index Futures has become a major plus for investors with China A-share exposure. The longer hours allows traders and market makers to react to off-market announcements and happenings in other global markets.

Source: Bloomberg 

Besides black swan events, governments are adding another element of surprise to the markets - central banks are throwing their hats into the devaluation game are releasing announcements during off market hours. These uncertainties and volatilities are translating into new opportunities and risks for both long and short gamma holders.  

On 21 November 2014, after the Chinese market closed, the People’s Bank of China announced a cut in interest rate. The People's Bank of China (PBOC) reduced one-year benchmark lending rates by 40 basis points to 5.6% and lowered one-year benchmark deposit rates by 25 basis points to 2.75%. European equities rallied. Similarly, SGX FTSE China A50 Index Futures, as illustrated below, soared on the announcement.

Source: Bloomberg 12 February 2015

A similar incident took place on 4 February 2015. China's central bank made an after-market announcement to cut bank reserve requirements, the first time it had done so in over two years, to unleash a fresh flood of liquidity to fight off economic slowdown and looming deflation.

Reserve requirements were lowered from 20% to 19.5% for big banks, a reduction that would free up RMB600 billion in reserves.

On 28 February, PBOC announced the reduction of one-year deposit rate by 25 basis points to 2.5% and the one-year lending rate will also drop by a quarter percentage point to 5.35%.

More Good Tidings in the Year of the Ram

Last week, in a bid to boost turnover under the Stock Connect scheme, Hong Kong Exchange and Clearing (HKex) announced plans to allow investors to short-sell Shanghai listed A-share under the Scheme from 2 March 2015. This marks the first reform of the Scheme since its launch on 17th November 2014.

However, like the Stock Connect Scheme, the latest initiative aimed at boosting the lacklustre turnover of the Stock Connect comes with several restrictions.  The short-selling ratio – the number of shares sold short as a proportion of the total number of the same stock held by all investors in Hong Kong at the beginning of the trading day, will be capped at 1% and no more than 5% over 10 consecutive days. Before short selling, they would need to borrow the stocks from brokers at a margin. Short sell orders will have to under pre-trade checks to ensure the borrowed stocks have been delivered at least one day before sale.

Market analysts do not expect the latest move to generate immediate and substantial results, noting that hedge fund managers had other means of implementing strategies and would not be rushing to participate in the new scheme. However, in the longer term, turnover is expected to improve as more fund managers get compliance and regulatory approval to trade through the link.  

Other longer-term catalysts include the possibility of lifting the total quota under the Stock Connect scheme, the inclusion of Shenzhen stocks under scheme, and inclusion of China A-share stocks by index providers like FTSE and MSCI which could enhance global investors’ demand.