The Uncertain State of Futures Trading in China

Unfortunately, at that time legislation did not keep pace with the growth of the markets and various types of abuse resulted. Insider trading, price rigging and provincial-level government manipulation all marked the early days of futures markets in China. With turnover estimated at Rmb10 trillion and speculation rampant, the system stalled in 1995 with the collapse of a large domestic securities firm, Shanghai International Securities Company, caught in a massive Treasury bond futures scandal and later forced to liquidate. On May 17 1995, the CSRC shut down all bond futures trading, and brokerages were given about two weeks to unwind their contract positions; this event marked the beginning of the consolidation of China's futures markets. On December 23 1996, the CSRC issued the Several Problems Concerning the Regulation of Acceptance of Securities Brokerages Circular, which effectively banned foreign investment in futures brokerages, as well as investment by foreign-invested enterprises and non-bank financial institutions in futures brokerages.

After the forced 1995-96 cool down, China's legislators recommitted their efforts to codify futures trading activities. In 1999 the State Council issued the Administration of Futures Trading Tentative Regulations, a fundamental guide to conducting futures transactions. In addition, in 2002, the CSRC reissued regulations on futures markets and futures brokerages, repealing the corresponding 1999 regulations. Today, three futures markets exist, in Shanghai, Dalian and Zhengzhou. They trade a narrow range of futures contracts, with Shanghai offering futures contracts on aluminium, copper and natural rubber, and the other two exchanges offering contracts on soybeans and wheat. In recent years, the combined effects of rising income and a dearth of alternate investment outlets have prompted the futures markets to slowly rebound. In 2002, aggregate turnover climbed to nearly Rmb4 trillion.

The Circular

The Circular signals a regulated opening to investors, and reflects a continued desire on the part of PRC legislators to balance investors' ability to diversify their China portfolios with the need of domestic enterprises to improve risk-management safeguards, gain technical expertise and enhance managerial skills. Although the Circular opens the futures market to investment by non-bank financial institutions, early reports from the CSRC indicate that the sector will remain off-limits to commercial banks and insurance firms for the time being, because respective industry regulations prohibit investment in futures brokerages. Thus for the interim, only securities firms appear qualified to invest in futures brokerages and utilize the opening offered in the Circular.

Another confusion arising from early interpretations of the Circular concerns futures brokerages accepting foreign investment. Though the Circular does in fact repeal the 1996 ban by the CSRC on foreign investment in futures brokerages, the lifting of this ban does not signal that the industry is open to foreign investment. Similar to the phenomena outlined in the above paragraph, the Circular does not supersede specific over-arching industry regulations. In this case, the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录) (the Catalogue) jointly promulgated by the State Development and Planning Commission, the State Economic and Trade Commission and the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) in 2002 remains the over-arching legislative framework governing foreign investment in PRC domestic industries. Under the Catalogue, foreign investment in futures brokerages is expressly prohibited. Further discussion with the CSRC and MOFTEC has reinforced this apparent contradiction, and until the Catalogue is revised foreign investment in futures brokerages remains prohibited. Subsequently, much of the excitement generated by the Circular appears premature, as the Circular merely sets the stage for further legislative reform that would indeed provide a genuine opening to foreign investors.

Additionally, should the Catalogue be revised, the Circular still does not signal a direct opening to foreign investors. Rather, the Circular requires that investors have PRC legal person status, effectively limiting foreign investors to investing in futures brokerages indirectly through foreign-invested enterprises (FIEs). The MOFTEC and State Administration for Industry and Commerce's Investment Within China by Foreign-invested Enterprises Tentative Provisions (the Reinvestment Provisions, issued July 25 2000 and effective September 1 2000) govern re-investment by FIEs, also known as second-tier investment. Thus in theory, a foreign investor could establish a domestic EJV securities firm¹ with a Chinese partner, gain PRC legal person status, and provided this new entity satisfies the requirements in the Circular and the Reinvestment Provisions, invest in a futures brokerage.

Additional requirements under the Circular mandate that investors have registered capital and net assets that total at least Rmb10 million, have posted profits for two consecutive years and have more than two years' operating experience. However, investors with combined registered capital and net assets totalling more than Rmb50 million are not subject to the profitability requirement, and need only have one year of operating experience. The participation requirements thus appear to favour large and established investors, re-emphasizing the belief that attracting this type of investor will mitigate the risk of foreign speculation on domestic markets. Risk management is of utmost importance to the CSRC in opening the financial services sectors, and this is especially true in opening futures markets given their historical volatility. As is standard for investment in financial institutions, investors are required to have a clean operating record with no major administrative violation within the previous two years.

Of additional interest is that the Circular does not require a minimum investment amount from investors. Furthermore, investors are not subject to the operating, profit, size or years-in-operation requirements in the case where total investment is less than 10% of the equity, and the investor does not have de facto control. This is a positive sign for those investors that are motivated to invest primarily in order to establish market position, but are reluctant to invest heavily in these untested markets.

Implications for Investors

In the PRC, futures brokerages act as intermediaries for futures investors, and are restricted from conducting trading for their own account. Thus, should the Catalogue be revised, the opening provided under the Circular does not permit foreign investors to trade directly, or even indirectly, in futures markets. Trading on futures markets is addressed in the 1999 State Council Regulations. Additionally, it is important to note the present-day limited scale of futures markets operations, that brokerages and futures investors conduct transactions in a limited number of commodities, and that the trading of bond and equity futures is prohibited.

Still, the nascent state of China's futures markets should not discourage investment. The need for hedging tools to mitigate risk will continue to increase in tandem with the growing sophistication of economic transactions, and China's futures markets will develop in line with this demand. Reports indicate that futures trading in fuel, oil, rice and sugar are in the works, and additionally, a number of brokerages are pushing the government to allow brokerages to conduct proprietary trading, asset management and consulting services. Thus, investors should view investment in futures brokerages as provided for in the Circular as an opportunity to secure market position pending a further loosening of regulations governing futures transactions and an expansion of the services that brokerages provide.

Conclusion

The Circular sets the stage for a dual opening: an external opening to foreign investors; and an internal opening to other financial services sectors (i.e., non-bank financial institutions). Providing the Catalogue is revised, the first opening is to foreign investors investing in futures brokerages indirectly through FIEs. Furthermore, given the Circular's lack of minimum investment requirements, it appears that PRC legislators have steered away from simply trying to attract massive amounts of foreign capital, and have moved towards enticing the right kind of foreign capital.

The second opening, perhaps more of a long-term goal, opens the financial services sector from within, permitting limited cross-investment by non-bank financial institutions, which is presently open to domestic securities brokerages. The Circular's enabling of investment in futures companies by domestic securities brokerages investment in futures companies indicates a potential transition to a mixed-investment model for the PRC financial services sector, a paradigm characteristic of countries with more developed financial markets. Additionally, permitting domestic securities firms to invest in futures brokerages is a further signal that China is committed to increasing the sophistication of futures trading, setting the stage to eventually offer trading in financial futures.

Foreign investors and financial institutions with hopes of investing in the PRC futures industry should carefully monitor relevant industry regulations surrounding investment in futures brokerages, and give the opportunity provided for in the Circular due consideration.

Endnote

1 CSRC, Establishment of Securities Companies with Foreign Equity Participation Rules, issued June 1 2002 and effective July 1 2002.

By Thomas Jones, Freshfields Bruckhaus Deringer