LV thạc sỹ_Strengthening the development of financial derivatives market in vietnam

Requirements to have a sound derivative market...19 2.4 Global derivatives market...22 2.4.1 Overview:...22 2.4.2 Korean Futures and option market...23 2.4.3 China futures and option mar

BACHELOR’S THESIS IN FINANCE

STRENGTHENING THE DEVELOPMENT OF FINANCIAL DERIVATIVES MARKET IN VIETNAM

Student’s name : ….

Hanoi,

TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION 7

1.1 RATIONALE 7

1.2 RESEARCH OBJECTIVES 8

1.3 RESEARCH METHODOLOGY 8

1.4 SCOPE OF RESEARCH 8

CHAPTER 2: THEORETICAL BACKGROUND ON FINANCIAL DERIVATIVES MARKET 9

2.1 Financial Derivatives 9

2.1.1 Definition 9

2.1.2 Uses and users of financial derivatives 10

2.1.3 Benefits and risks of financial derivatives 11

2.2.1 Forwards 12

2.2.2 Futures 13

2.2.3 Options 14

2.2.4 Swaps 16

2.3 Financial derivatives market 16

2.3.1 Definition of financial derivatives market 16

2.3.2 Derivatives trading in the financial derivatives markets: 17

2.3.3 Requirements to have a sound derivative market 19

2.4 Global derivatives market 22

2.4.1 Overview: 22

2.4.2 Korean Futures and option market 23

2.4.3 China futures and option market 24

CHAPTER 3 CURRENT SITUATION OF FINANCIAL DERIVATIVES MARKET IN VIETNAM 27

3.1 Development of financial derivatives market in Vietnam 27

3.1.1 Background conditions for the development of financial derivatives market in Vietnam 27

3.1.2 Development of financial derivatives market in Vietnam 28

3.2 Legal framework for financial derivatives market in Vietnam 28

3.3 Current situation of Vietnam financial derivatives market 30

3.3.1 Participants 30

3.3.2 Financial derivatives instruments in Vietnam 33

3.3.3 The performance of financial derivatives market in Vietnam 36

3.3.2 Structure of financial derivatives instruments in Vietnam 39

3.4 Evaluation the development of financial derivatives market in Vietnam 43

3.4.1Results of the development of financial derivatives market in Vietnam 43

3.4.2 Existing issues in the development of financial derivatives market in Vietnam .44 3.5 Recommendations for the development of financial derivatives market in Vietnam 47

3.5.1 Regulation about exchange rate limitations 47

3.5.2 Requirements about capital and collateral in trading financial derivatives market 48

3.5.3 Requirements about re- insurance in international markets 48

3.5.4 Open- markets for all financial institutions that are trading financial derivatives instruments 48

3.5.5 Open-markets for financial derivatives trading VND 48

3.5.6 Requirements about financial statements 49

3.5.7 Using an industry-standard transaction for derivatives trading 49

3.5.8 Improving the current accounting system 49

3.5.9 Increasing the liquidity of the system 49

3.5.10 Recruitment and Educating people 49

CHAPTER 4 CONCLUSION 51

REFERENCES 52

Since the global crisis in 2007-2008, economists have argued about reasons ofthe economic downturn, including the usage of financial derivatives The using offinancial derivatives is controversial even in developed countries such as the US orEurope Therefore, it is easy to understand that applying derivatives instrument,especially financial derivatives is facing many in emerging countries such asVietnam However, financial derivatives already have a long development process

in the world and they are proved to be effective and beneficial for financialinstitutions, investors and the economy as a whole Therefore, the question is notabout applying the instruments or not but how to apply and reduce the risk comingalong Having a thorough understanding about financial derivatives is a compulsorystage which will build up the development of these instruments in the financialmarket of Vietnam

The research has three main parts, including:

- Theoretical background on financial derivatives market

- Current situation of financial derivatives market in Vietnam

- Recommendations for the development of financial derivatives market inVietnam

BIDV Bank of Investment and Development of Vietnam

LIST OF TABLES

Table 3.1 Revenue from financial derivatives activities in some commercial banks 37Table 3.2 Revenue and Profit from Financial Derivatives Instruments (FDIs) insome Vietnam commercial banks 38Table 3.3 Structure of transaction values of each financial derivatives instrument atEximbank 40Table 3.4 Structure of transaction values of each financial derivatives instrument atSacombank 40Table 3.5 Structure of transaction values of each financial derivatives instrument atACB 41

LIST OF CHART

Chart 3.1: Participants in the financial derivatives market 31Chart 3.2 Revenue from financial derivatives trading in some commercial banks .37Chart 3.3 Structure of transaction values of each financial derivatives instrument atEximbank 41Chart 3.4 Structure of transaction values of each financial derivatives instrument atSacombank 42Chart 3.5 Structure of transaction values of each financial derivatives instrument atACB 42

CHAPTER 1: INTRODUCTION

1.1 RATIONALE

Strong financial system is a compulsory factor in order for a country toachieve sustainably economic development In the case of Hong Kong andSingapore, stable financial system is the key to push the economy and protect itfrom fluctuations of global events

In Vietnam, the financial system is still in weak form Uncertainties of theeconomy such as changes of interest rates, exchange rates, gold prices…can easilyaffect our banking system and then, manufacturers Under pressure of improvingand modernizing financial activities, developing a derivatives market is indiscussion for many times, especially after the global financial crisis in 2007.However, until now, Vietnam is still not having an official derivatives market andlacking many supporting conditionsfactors to build up this market

Initially, the research was aimed at understanding derivatives instruments, itstheir role in the financial and economic system However, because of timeconstraint, this study focuses only on financial derivatives instruments They arenow already established as products of some commercial banks in Vietnam.Nonetheless, the understanding of organizations and individuals about theircharacteristics and usefulness is still limited and the application is still havingshortcomings is problematic

The research will identify characteristics and usefulness of financialderivatives instruments which are currently in use in Vietnam market Moreover,the situation of derivatives trading in Vietnam also is analyzed Finally, therecommendations will be concluded with some references from other markets such

as China and Korea

1.2 RESEARCH OBJECTIVES

The study aims at adding one useful reference for further study and researchabout the market of financial derivatives market in Vietnam There are three mainobjectives for the research, including as below: The research will have to providereaders a thorough view about the bellowed aspects:

- Providing Fundamental Basic but full understandings of the financialderivatives market and its related contents

- Analyzing the Ccurrent situation of the development of the financialderivatives market in Vietnam

- Suggesting rRecommendations for the strong and sustainable development

of Vietnam’s financial derivatives market

1.3 RESEARCH METHODOLOGY

The study mostly uses the secondary sources of data and information Tha is tosay That means the research contains references from some published books,articles, and news… Moreover, there are also information and data coming fromVietnam commercial banks’ financial statements The data is useful to analysis thecurrent situation of the financial derivatives market in Vietnam

1.4 SCOPE OF RESEARCH

The research focuses on the financial derivatives market in Vietnam.Nonetheless, because of time constraints, it can not provide a detailed and deepanalysis about all the aspects involving The research targets Vietnam commercialbanks to mostly investigate the current situation of the market since it is not difficult

to collect the data of these banks; and it provides the quantitative evidences for theresearch

CHAPTER 2: THEORETICAL BACKGROUND ON FINANCIAL DERIVATIVES MARKET

2.1 Financial Derivatives

2.1.1Definition

A derivative is a contract with seller and buyer The value of each contract

depends on the price of other assets that we call “underlying assets” which aresubject to changing market prices

Unlike debt instruments, no principal amount is advanced to be repaid and noinvestment income accrues Derivatives are also totally different from securities.They are financial instruments that are mainly used to protect against and managerisks, and very often also serve arbitrage or investment purposes, providing variousadvantages compared to securities Moreover, the time between entering into thecontract and the ultimate fulfillment or termination of the contract, can be verylong- in some cases more than ten years While Whereas, transactions of securitiesare fulfilled within a few days

Derivatives come in many varieties and can be differentiated by how they aretraded, the underlying they refer to, and the product type:

Type of derivative and market place : Derivatives contracts could be traded

on the counter (OTC) with mostly individually customized contracts or on exchangewith standardized contracts

- -

- Type of underlying assets : Underlying assets include financial assets andcommodity asset Respectively with each kind of underlying assets, there arefinancial derivatives and commodity derivatives

- Type of products : The four main types are forwards, futures, options andswaps

Financial derivatives are financial instruments that are linked to a specificfinancial instrument or indicator or commodity price such as stock price, foreigncurrencies, and interest rate, gold prices… through which specific financial riskscan be traded in financial markets in their own right Because of the research scope,the study is only focused on financial derivatives, but not commodity derivatives

2.1.2 Uses and users of financial derivatives

Financial derivatives can be used with different objectives:

Risk management or Hedging: derivatives are a tool for companies and other

uses to reduce risks Financial derivatives help to eliminate uncertainty byexchanging market risks, commonly known as hedging Firms and financialinstitutions use financial derivatives to protect themselves against changes inexchange rates, interest rates, securities prices…These users would be calledhedgers

Investment: Derivatives can serve as investment vehicles Derivatives are an

alternative for investors to investing directly in assets without buying and holdingthe asset itself

Reduced transaction costs: sometimes derivatives provide a lower cost way

to effect a particular financial transaction The total transaction cost of buying aderivatives contract on a major European stock index is about 60 percent lower thanthat of buying a portfolio of underlying assets

Speculation: Derivatives also allow investors to take positions against the

market if they expect the underlying asset to fall in value Typically, investorswould enter into financial derivatives contract to sell an asset that they believe isovervalued, at a specified future point in time and to buy an asset that they believe

is undervalued Such strategies reduce the risk of assets becoming excessivelyunder- or overvalued

Because financial derivatives are new in the investment world and it is noteasy to understand the characteristics and strategy to use derivatives, these contracts

are mainly designed for professional users Moreover, some financial constraints,

for example: the cost or the floor value of a contract would explain for the fact thatthe lead the instruments are more appropriate for professional users

2.1.3Benefits and risks of financial derivatives

- Allowing investors to trade on future price expectations

- Havinge very low total transaction costs compared to investing directly in theunderlying assets

- Allowing fast product innovation because new contracts can be introducedrapidly

- GettingCan be tailored to the specific needs of any user

2.1.3.2 Risks:

A number of risks are posed by the financial derivatives markets They may beclassified into two categories:

- (i) Firm-specific risks

- (ii) Systematic risks that threaten both the financial system and the realsector

The risks at the level of the individual firm include credit or defaultrisk, legal risk, market and liquidity risk, and operating or management risk.Systematic risk is linked to the greater competition between banks and non-bank financial institutions, greater interconnectedness of financial markets,

increasing concentration of derivatives trading, the reduced disclosure offinancial information through off-balance sheet activities, and financial andtelecommunication innovations that have intensified reactions to marketdisturbances.

Specifies the quantity and exact types of the asset or commodity the sellermust deliver

Specifies delivery logistics, such as time, date and place

Specified the price the buyer will pay at the time of delivery

Obligates the seller to sell and the buyer to buy, subject to the abovespecifications

The time at which the contract settles is called the expiration date The asset orcommodity on which the forward contract is based is called the underlying asset Aforward contract requires no initial payment or premium The contractual forwardprice simply represents the price at which consenting adults agree today to transact

in the future, at which time the buyer pays the seller the forward price and the sellerdelivers the assets

The payoff to a contract is the value of the position at expiration

The payoff from a long position (when an investor buys the contract, it says he

is in a long position) in a forward contract is

P = S - XWhere S is a spot price of the security at time of contract maturity, X is the delivery price Similarly, the payoff from a short position (when an investor sells a contract, it says he is in a short position) is

P = X - S Any forward or futures contract-indeed, any derivatives contract- has creditrisk., which mean there is a possibility that the counterparty who owes money fails

to make a payment

2.2.2 Futures

As with forwards, futures contracts represent a commitment to buy or sell anunderlying asset at some future date Because futures are exchange-traded, they arestandardized and have specified delivery dates, locations, and procedures

Although forwards and futures are similar in many respects, there aredifferences:

- Whereas forward contracts are settled at expiration, futures contracts aresettled daily The determination of who owes what to whom is called marking-to-

market Frequent marking-to-market and settlement of a future contract can lead topricing differences between the futures and an otherwise identical forward.

- As a result of daily settlement, futures contracts are liquid-it is possible tooffset an obligation on a given date by entering into the opposite position

- Over-the-counter forward contracts can be customized to suit the buyer orseller, whereas futures contracts are standardized

- Because of daily settlement, the nature of credit risk is different with thefutures contract In fact, futures contracts are structured so as to minimize theeffects of credit risk

There are typically daily price limits in futures markets A price limit is amove in the futures price that triggers a temporary halt in trading

To sum up, a future contract is equivalent to a forward contract that is settleddaily or “market-to-market” and written simultaneously as a new forward contract

2.2.3Options

An option contract gives the purchaser the right, but not the obligation, to buy

or sell at or within a certain point in time in the future at a pre-determined price.Options are categorized into two different kinds: call option and put option

Call option: a call option is a contract where the buyer has the right to buy,

but not the obligation to buy

At the time the buyer and seller agree to the contract, the buyer must pay theseller an initial price, or premium This initial payment compensates the seller forbeing at a disadvantage at expiration Contrast this with a forward contract, forwhich the initial premium is zero

- Expiration: the expiration of the option is the date by which the option musteither be exercised or it becomes worthless.

- Exercise style: the exercise style of the option governs the time at whichexercise can occur In an European-style option, exercise could occur only atexpiration In an American-style option, the buyer has the right to exercise at anytime during the life of the option If the buyer can only exercise during specifiedperiods, but not for the entire life of the option, the option is a Bermudan-styleoption

Put option: a put option is a contract where the seller has the right to sell, but

not the obligation

A put must have a premium for the same reason a call has a premium

Other terminology for a put option is the same as for a call option, with theobvious change that “buy” becomes “sell”

If S is a final price of the option underlying security, X is a strike price and OP

is an option price, than the profit is

Long Call: P = S - X - OPShort Call: P = X - S + OPLong Put: P = X - S - OPShort Put: P = S - X + OP

2.2.4 Swaps

A swap is a contract calling for an exchange of payments over time One partymakes a payment to the other depending upon whether a price turns out to begreater or less than a reference price that is specified in the swap contract A swapthus provides a means to hedge a stream of risky payments

The two most widely used types of swap are interest rate and currency swap

A company may swap a floating rate of interest for a fixed rate, or vice versa.For example, a company might ideally want to borrow in the fixed rate market, butfinds it cannot do so at any reasonable rate It might therefore take out a floatingrate loan, and enter into a swap contract under which it pays amounts equivalent tofixed rate interest on a notional principal sum, and receives amount equivalent tofloating rate interest on the same notional principal The net effect is the same as if

it had borrowed at a fixed rate of interest

Currency swaps are indeed sometimes referred to as cross-currency interestrate swaps

Under a currency swap, the parties exchange ‘interest’ payments on a principalamount denominated in one currency for ‘interest’ on a principal amountdenominated in a second currency Unlike interest rate swaps, however, theprincipal amounts are actually exchanged at the end of the swap period, at anexchange rate agreed in the contract

2.3 Financial derivatives market

2.3.1 Definition of financial derivatives market

The term “financial derivatives market” is generally understood as a market inwhich financial derivatives products are traded

Derivative contracts can either be traded in a public venue such as aderivatives exchange, or privately over-the-counter (OTC) While derivatives wereinitially mostly traded in public venues, today the bulk of derivatives contracts istraded OTC (roughly 85% of the global market in terms of notional amountsoutstanding)

Comparison of Exchange & Over-the-Counter Trades of Financial Derivatives

Category Exchange trade Over-the-counter trade

Trade

Location Exchanges

Contracts are mostly concluded via phone, etc through dealers orbrokers

Daily settlement In most cases, only the

balance is settled before maturity through

offsetting transaction

In most cases, goods are delivered or transferred at maturity

Deposit Deposit at exchange

Dealers and brokers set credit limits per customer or demand deposits

2.3.2 Derivatives trading in the financial derivatives markets:

Whether a derivative contract is standardized or tailor-made determines how

the market has structured the delivery of trade and post-trade chain functions:

- Trade execution: Trade execution occurs when two counterparties agree to a

transaction On-exchange, orders are matched automatically on derivative

exchanges' order books OTC execution may take a variety of forms, depending on

contracts' standardization and market preference, e.g occurring by phone or

electronically on "private" exchanges Electronic trading has increased rapidly in

recent years, driven in part by the advent of hedge funds

- Trade confirmation: After the execution, the terms of the trade need to

verified (affirmation) and confirmed On-exchange, this occurs automatically withinthe exchange's matching system As regards OTC, the most standardized OTCcontracts use electronic affirmation and confirmation third-party services

- Clearing: Contrary to equity markets, where the post-trade aspects (e.g.

exchange of cash and transfer of ownership) are completed quickly (less than 2/3days), derivative contracts involve long-term exposure, as derivative contracts maylast for several years This leads to the build-up of huge claims betweencounterparties, with of course the risk of a counterparty defaulting Clearing is thefunction by which these risks are managed overtime On-exchange, clearing is done

on a Central Counter-party (CCP) OTC, clearing is mostly done bilaterally betweenthe parties involved but increasingly on a CCP

The central counterparty (CCP)

A CCP acts as a buyer to all sellers

and a seller to all buyers As the CCP

assumes the counterparty risk of all

trading parties it must protect itself so

that it can always fulfill its obligations

Different lines of defense are commonly

established to achieve this: daily

compensation of losses (and gains),

liquidation of open positions when a

trading party is in default,

collateralization of maximum expected

daily losses, a clearing fund, support

from a highly rated guarantor and finally

the clearing house’s equity capital

The daily compensation of all

A clearing fund is usuallyestablished as a further line of defense Ifthe aforementioned two arrangements(automatic liquidation of open positionsand collateralization) are still notsufficient to honor obligations to othertrading parties when one trading partydefaults, these obligations are fulfilledfrom this fund All trading parties mustcontribute to the clearing fund and ofteneven replenishment requirements exist

A further line of defense can be aguarantee from a highly rated creditinsurer or bank that steps in if the CCPruns low on funds

Finally, if even the clearing fund

losses and gains by the trading parties

ensures that no trading party runs up

losses over the life of its contracts that it

cannot cover in the end If a trading

party cannot compensate its losses

during or after a trading session all its

contracts can be automatically closed out

by entering offsetting contracts

If a trading party defaults, all its

open positions are liquidated to prevent

the defaulting trading party potentially

running up further losses Collateral,

which is pledged to the clearing house,

serves to cover any losses that cannot be

compensated by the trading party The

amount of collateral is based on the net

market risk the trading party is exposed

to from all its open contracts For this,

the CCP must regularly calculate the

market risk resulting from each trading

party’s position

arrangement or guarantees are notsufficient to cover the losses from failingtrading parties the clearing house’sequity capital serves as a last line ofdefense Combinations of these lines ofdefense make it almost impossible forthe CCP to default, thereby eliminatingcounterparty risk for all trading parties.CCPs usually have the highestcreditworthiness in the market Inaddition, by being integrated withexchanges’ trading processes, manualerrors or errors from the delayedhandling of trade confirmations can beavoided or at least minimized

2.3.3 Requi rements to have a e sound derivative market

Financial derivative instruments are very effective for users in many usingpurposes However, they also contain many risks and difficulties based on theircomplex nature Therefore, building an effective and transparent financial derivativemarket is very important in order to improve the advantages of the instruments.There are some requirements to have a sound derivative market They arestated as below:s

First, there should be an efficient, liquid, and integrated cash market (either forbonds, equities, other assets, or commodities) that is broadly market determinedrather than driven by administered prices Restrictions can lead to less efficientmarket Moreover, modern IT, trading platforms, and internet trading often enhanceliquidity.

There needs to be a compelling economic rationale to develop new derivativeproducts

Prior to trading of derivatives, both long and short positions should be allowed

in the underlying cash market

Market participants that intend to deal in derivatives should be licensed andtrained They should be required to follow best practice governance and accountingstandards and to hold sufficient capital for their respective risk positions Also,intermediaries must be accountable to deal only with fit and proper clients whounderstand characteristics and risks of derivatives

Tax regulations should provide a level playing field for all cash andderivatives trading If any one segment is exempted from taxes, it may initially helpmarket development, but will not be sustainable if that market becomes a substitutefor tax arbitrage reasons Typically, capital gain taxes are considered more efficientand less distortionary than transaction taxes

The major institutional setup of a derivatives exchange will ideally beimplemented through a single demutualized exchange Typically, index futures areamong the first products before options on individual assets are introduced Safetycushions of the exchange must include appropriate capital and a sound marginingsystem

Clearing and settlement of derivatives products should be executed through asingle counterparty (CCP) with multilateral multi-product close-out nettingarrangements Typically the exchange or its subsidiary will provide these services,which may also cover OTC trading as it will further strengthen the prevalent OTCdesign of bilateral ISDA master agreements

Local accounting standards should be upgraded to IFRS, including market principles as required under IAS39 Full disclosure of all derivativepositions should be required.

mark-to-Subsequently, more tailored or innovative OTC derivative products may bedesigned, such as credit default swaps Typically, intermediaries are banks whichshould receive specific regulatory clearance and should support their risk positionswith adequate capital

Finally, the investor base may be further broadened, for example by attracting

a larger share of foreign institutional investors or by opening up new ETD marketsfor retail investors This can be facilitated by strategic partnerships amongexchanges, modern trading platforms, and reduced transaction costs, as well as byinnovative products that meet new hedging needs

(Source: Chapter for Asian Financial Market Development, the World Bank)

In summary, solid product design, strong regulation, and sound marketinfrastructure are three key components for the development of sound derivativemarkets.

2.4 Global derivatives market

2.4.1Overview:

The derivatives market can be described as highly dynamic with plenty ofmarket entries There are no legal, regulatory or structural barriers to enter thederivatives market Almost all derivatives exchanges across the world have beencreated during the last three decades only

The United States was home to the first wave of equity options exchangefoundations in the 1970s with a lot of new knowledge related to options valuationand the introduction of computer system A second wave of new derivativesexchanges occurred in the 1980s and early 1990s in Europe During that time, afinancial derivatives exchange was established in almost every major WesternEuropean financial market Most of these organizations formed their own clearinghouses In such a dynamic market, the already large number of derivativesexchanges is likely continue growing

In emerging markets, activities related to financial derivatives are alsointensive Three derivatives operations have commenced trading in the Middle Eastsince 2005: Dubai Gold Exchange, Kuwait Stock Exchange, and IMEX Quatar.India saw four new derivatives exchanges set up between 2000 and 2003: NationalStock Exchange of India, Bombay Stock Exchange, MCX India, and NCDEX India.China has seen the establishment of two derivatives exchanges since 2005:Shanghai Futures Exchange and China Financial Futures Exchange

Below are experiences from Korea and China The two markets contain somesimilarities as Vietnam and can provide the development of financial derivativemarkets in Vietnam some useful lessons:

2.4.2Korean Futures and option market

South Korean economy is an industrial economy In the ten years since 1995,the trading activity on the Korean Stock Exchange, KSE, has led to huge increases

in trading of derivatives Since the KSE launched futures, Kospi 200 Index, in May

1996 and options on the stock index in July 1997, the traded volume has increasedsignificantly, creating huge liquidity The options contract now ranks as one of theworld’s biggest listed derivatives, measured in both volume and value Just eightyears after the debut of these markets, the average daily volume was 210,000futures and 11,500,000 options

There are several key factors to be considered for this degree of success ofderivative markets in Korea:

First, the root cause is the entry of households into the market Trading in thefinancial market is now part of modern Korean culture, and there is a widespreadknowledge of the fundamental mechanisms of the futures and options especiallyafter the financial crisis in the late 1990s Individual investors account for two-thirds of overall trading volume At any time during day or night, there areeducational programs on the television about technical analysis and strategy forstocks and derivatives Trading the market is part of the daily life of the people inKorea

Second key factor is the small size of these contracts The participate ofhousehold could be the motivation of this characteristic In mid- October 2002, thevalue of a single futures contract on the Kospi 200 was approximately 42.5 millionwon, which at the then exchange rate was equivalent to $ 34,000, making it roughlycomparable in size o the E-mini S&P 500 The options contract is even smaller,representing one-fifth of the value of the futures contract

The third key factor is the formidable penetration of the Internet in Koreansociety, which has allowed online trading to develop very rapidly since 1999 Thenumber of people with Internet access rose from 1.6 million in 1997 to 10.9 million

in 1999 to 24.4 million in 2001 The ratio of online securities trading to total

securities trading has followed similar pattern, moving from 1.9% in 1998 to 19% in

1999, 46.6% in 2000, and 52.3% in 2001 These figures make Korea the worldleader in online securities trading The low transaction cost is considered to be onereason for the popularity of online trading in Korea

2.4.3 China futures and option market

Chinese government started to develop the Chinese financial market from 1990s China’s spot and futures markets have been developing since the 1980s, intandem with the market reforms and the liberalization of the country’s economy.China Securities Regulatory Commission (CSRS) is the sole national securitiesregulatory body It was mandated in October 1992 to regulate all of China’ssecurities and futures markets Unlike the stock exchanges of most countries,Chinese stock exchange is a branch of the government

late-In 1995, due to the weak risk management procedures, there was a scandalinvolving chaotic trading of bond futures contracts in Shanghai Stock Exchange.Then, the government shut down the bond futures markets and scaled back trading

in commodity futures Therefore, no financial derivatives have been permittedsince, although there is in mid-2000s discussion of a possible index futures contract.There are several factors to be discussed regarding the failure of bond futures andsubsequent restriction on the introduction of financial futures Mostly, China’sfutures markets are closed to foreign investors and brokerage firms Moreover,Chinese futures companies, which number around 200 or so, serve primarily asagents, and are not involved in broader business dealings Stock and fundbrokerages cannot currently participate in futures transactions In December 2001,China Securities Regulatory Commission announced that Shanghai FuturesExchange was preparing to launch stock index futures However, there was notimeframe in the announcement

To avoid a repeat of the events in the mid-1990s, China will have to develop astable regulatory system for its futures market backed up by strong enforcement.Nonetheless, there are other barriers to reintroduce financial futures market in

China They are including: the lack of understandings the significance andcharacteristics of the market in majority of Chinese investors; and the immaturity ofChina’s market oriented economy.

Failure of Futures Exchanges: the case of Shanghai

China establishes the Shanghai Stock Exchange in 1990 and opened thetrading of government bond futures through 50 brokerage firms to the public inOctober 1993 In a short period, over 30 exchanges opened up and over 50 futurescontracts were traded in a casino-like atmosphere In 1994, hot money migratedfrom equity to futures markets for government bonds, which were traded mostly inShanghai, but also in Beijing, Shenzhen, and Wuhan New regulations and positionlimits were then announced by variable interest rates that were adjusted discreetlywith so-called “inflatin subsidies”, and they were settled with physical delivery thatoften caused shortages because open interest in futures markets far exceeded thephysical amount of outstanding bonds On 23, February 1995, the day beforeinflation subsidies were announced for illiquid bonds issues in 1992, one smallbrokerage (which was owned by the Ministry of Finance) took long positions inthese bonds, that caused losses from short positions at the largest broker, ShanghaiInternational Securities, which then tried to corner the market by selling short thesefutures in the amount of $ 26 billion, exceeding position limits by 20 times Illegaltransactions were continuing over the next three months, and the government thensuspended all bond futures trading on 18, May 1995 The hot money thenimmediately returned to equity market, which posted their largest gain of 31% onthe same day

Three critical lessons can be drawn from this case: First of all, a sensibledesign of derivative products is critical As a prerequisite, there needs to be a wellfunctioning and liquid cash market, where risk management has been tested,volatility is within reasonable limits, and both long and short positions can beefficiently traded There also needs to be an economic rationale to establish newderivative products that focus on hedging and that do not created moral hazard The

most important lesson is that derivative markets can create systematic risk if prices

of underlying assets are not market-determined Therefore, Chinese interest ratesneed to be fully liberalized

Second, the market infrastructure at derivatives exchanges and clearing housesneeds to be soundly developed The exchange also needs to establish a soundmargin system and strict position limits that are enforced in real time In the case ofChina, it appears that governance and clearing functions need to be strengthenedsignificantly and that margin requirements need to be raised to three sigma levels.Third, transparent legal and regulatory structures as well as a level playingfield are important preconditions as well Clear accountability for a lead regulatorand for market participants needs to be establishes, and the legal framework mustsupport strict enforcement Moreover, strong coordination between regulators iscritical to close any loopholes and ensure strict enforcement of rules