As Return of Chinese Gov’t Bond Futures Nears, Experts Pore over Details; Nearly two decades after market was suspended because of short sellers’ scam, traders and analysts wonder if new approach will protect investors

09.03.2013 17:09

As Return of Gov’t Bond Futures Nears, Experts Pore over Details

Nearly two decades after market was suspended because of short sellers’ scam, traders and analysts wonder if new approach will protect investors

By staff reporters Fan Junli, Zheng Fei and Cao Wenjiao

(Beijing) – Securities traders and analysts are going over the details of the new government bond futures that will hit the market soon – after a hiatus of nearly two decades – to see if they can better protect investors against fraud and other risks. The first batch of three contracts, all based on five-year government bonds, will be opened for trading from September 6 on the China Financial Futures Exchange (CFFEX), the securities regulator said last month.Trading on the first day will be limited to the price range of 4 percent higher or lower than the benchmark set by the exchange, the CFFEX said when announcing the regulation for the futures on September 2.

Also published were the revised minimum margin requirements for the futures contracts, which are set at 2 percent in normal times, 3 percent on the 10th of the month before the delivery month and 5 percent on the 20th. In the draft regulation, which the exchange released for feedback in July, the required margin rate for the last stage was 4 percent.

Raising margin requirements gradually is meant to reduce the risk of buyers defaulting on contracts, analysts say. In mature overseas markets for government bond futures, margin deposits do not need to rise over time.

The CFFEX has also imposed ceilings on traders’ positions in the market. The sooner a contract expires, the smaller the open position a trader can have on it.

Also, it will monitor traders’ margin deposits in real time. Those whose margin falls short of demand will be barred from trading the bond futures. Failure to honor a contrast can result in a penalty of up to 2 percent of the transaction amount, the regulation says.

All the precautions were taken so a scandal that shocked the government into shutting down the market 18 year ago would not be repeated, analysts say. In 1995, three years after the debut of government bond futures in the country, a securities firm betting short on a contract coded 327 stunned the market by putting up an egregiously large amount of sell orders shortly before the contract’s trading closed.

The exchange let the orders pass even though the firm did not have a large enough margin deposit. A great number of long-position traders, including a wholly owned subsidiary of the Ministry of Finance, were burned by the ensuing plunge in the price of the contract.

Though the illegal transactions were quickly nullified and the perpetrators jailed, the government decided to close the market over concerns that its regulations and risk control mechanisms were far from complete.

Flood Fears

Calls for restarting the futures market gained strength in recent years, with investors holding many more government bonds and saying that they need hedging tools. By the end of last year, the amount of outstanding bookkeeping government bonds exceeded 7 trillion yuan, or roughly 70 times the amount in 1995.

“Many market participants have gradually realized that the optimal moment to reintroduce government bond futures as a tool to hedge against the risk of interest rate fluctuations has come,” said Hu Yuyue, professor at Beijing Technology and Business University.

In particular, he said, banks will find the futures useful because they face liquidity and interest rate risks, as seen in the unusual liquidity shortage which startled the interbank market in May and June.

In fact, the futures are designed primarily to serve the risk-hedging needs of commercial banks, which hold the majority of government bonds, a source familiar with the drafting of the regulation said. “If banks do not get involved, the product would be pointless,” he said.

There is much apprehension, however, that banks may flood the market with short orders because they stand to lose if the government bonds they hold become cheaper. Some say that is unlikely to happen. Despite holding the majority of outstanding government bonds, the amount which banks intend to use for trading is only several hundreds of billions of yuan, a fraction of the expected turnover on the futures market, Li Qian, an executive of the Industrial and Commercial Bank of China, said.

A source close the CFFEX said: “The big banks hold nearly 90 percent of their government bonds to maturity and the other 10 percent for trading.”

That is because holding the bonds to maturity is essentially a risk-free investment, which can also pay off decently, analysts say. The average annual yield of the big banks’ government bonds portfolio is often higher than 4 percent.