QFIIs trading on stock index futures

On May 4 2011, the China Securities Regulatory Commission (CSRC) issued the Guidelines for the Participation in Stock Index Futures Trading by Qualified Foreign Institutional Investors (合格境外机构投资者参与股指期货交易指引) (the Guidelines) which came into force on the same day. The Guidelines allow Qualified Foreign Institutional Investors (QFIIs) to trade onshore stock index futures (SIFs) on the China Financial Futures Exchange (CFFex), which marked a milestone of the opening of the stock derivative market to foreign institutional investors.

Implications

Before the enactment of the Guidelines, QFIIs were only permitted to trade shares, bonds and securities investment fund units publically tradable on the Shenzhen and Shanghai Stock Exchanges. The Guidelines, for the first time, provide QFIIs with a necessary hedging tool to manage risks in China's volatile stock market.

Allowing QFIIs to participate in trading SIFs was one of the consensuses reached at the Sino-US Strategic Economic Dialogue held in May 2010. While the promise of the PRC government appears to have materialised, it is evident from the restrictions included in the Guidelines that the regulators clearly have concerns about market stability and are taking cautious steps in the process of deregulation.

The Guidelines impose a series of compliance and supervisory responsibilities on QFIIs, custodian banks and futures companies. Most notably: (i) QFIIs are only permitted to participate in SIFs trading for hedging purposes, and are not permitted to use SIFs as a means to develop and sell financial derivative products in offshore markets; (ii) QFIIs are only permitted to trade SIFs within their approved hedging quota, which is lower than their existing investment quota approved by the State Administration of Foreign Exchange (Safe) ; and (iii) There are also daily trading limitations on QFII trading of SIFs.

Main restrictions

The main restrictions and requirements provided in the Guidelines on QFIIs' SIFs trading are as follows:

1. Trading limits

In accordance with the Guidelines, a QFII may only participate in SIFs trading for hedging rather than for speculative or arbitrage purposes and is required to comply with the relevant rules of the CFFEx. Limiting the purpose of QFIIs' SIFs trading to hedging only will prevent a QFII from providing its clients with synthetic exposures to the onshore SIFs market. In fact, the CSRC specifically states in the commentary on the consultation draft of the Guidelines that it is an intention of the regulators to prevent QFIIs from using SIFs as a means to develop and sell financial derivative products in offshore markets.

In accordance with the Guidelines, the hedging activities of a QFII must also comply with the following requirements:

(i) At the end of each trading day, the total position held by the QFII shall not exceed the QFII's investment quota as approved by Safe. According to the CSRC's commentary on the consultation draft of the Guidelines, the total position held by the QFII refers to the aggregate of the QFII's long position and short position without netting.

(ii) During each trading day, the total trading value (excluding closing position) shall not exceed the QFII's investment quota. This aims to restrict the frequency of trading in a trading day. Moreover, if a QFII's day-end position breaches the restriction as a result of price fluctuation, it is required to rectify such a breach within 10 trading days.

2. Hedging quota

As mentioned above, the “investment quota” of a QFII as approved by Safe is different from the hedging quota approved by the CFFEx. Under the QFII regime, before a QFII can invest in the onshore market, it is required to apply to Safe for an investment quota. Within the investment quota granted by Safe, a QFII can remit capital in foreign currency into China and convert the capital into renminbi (Rmb) for the purpose of trading A-shares and other permitted Rmb-denominated instruments. The Guidelines provide that a QFII participating in SIFs trading must apply to the CFFEx for hedging quota, but, it is not made clear how the hedging quota of a QFII will be determined.

3. Capital safety monitoring system

QFIIs, its custodian banks and domestic futures companies will have to comply with CFFEx's trading rules in determining the form of settlement, such as deposit custody, trading execution, capital allocation and clearing, and shall put in place a capital safety monitoring system. There are similar requirements for onshore investors' participation in SIFs trading. QFIIs trading SIFs are also required to comply with the account segregation requirement under the general QFII regime.

4. Obligations of information disclosure

In accordance with the Guidelines, QFIIs must strictly fulfill the obligation of information disclosure in accordance with the relevant laws, regulations and relevant rules of the CFFEx. The Guidelines are not clear as to whether a QFII's obligation of information disclosure when participating in SIFs trading is different from onshore investors' and how to implement the obligation by the QFII. The relevant official of the CSRC states that the CSRC will further explain this point in detail on a case-by-case basis.

5. Responsibilities of futures companies and custodian banks

The trading of SIFs can only be carried out through a CFFEx member. Currently, CFFEx members are limited to PRC-licenced futures companies. In accordance with the Guidelines, a QFII may engage a maximum of three futures companies for the execution of trades. This is similar to the existing rules allowing a QFII to engage a maximum of three securities companies for trading A-shares.

A QFII may only nominate one custodian bank for handling the deposit of its Rmb capital, and the settlement between its deposit accounts opened with the custodian bank and the trading accounts opened with the futures companies. As required under the general QFII regime, custodian banks are obliged to report to the CSRC and Safe, on a monthly basis, the basic information of the account balance, trading activities and portfolio investment of QFIIs, as well as provide a timely report on any findings of irregular or illegal trading activities of QFIIs.

Looking ahead

China launched the trading of SIFs on April 16 2010, but to date the market is still of a small scale and is dominated by retail investors. QFIIs' participation in SIFs trading will bring fresh capital as well as expertise to the SIFs market and may help to mitigate volatility. However, given the restrictions on the type and volume of SIFs trading by QFIIs, some analysts commented that this move, though in a right direction, has more of a symbolic impact on the SIFs market.

It is not surprising for the Guidelines to be overly-restrictive at this stage and for regulators to have path dependence in opening up the SIFs market to QFIIs. If we look at the history of the QFII regime in China, it took nine years for the CSRC and Safe to gradually increase the investment quota of QFIIs, and to set up a relatively mature trading system and account management system for QFIIs. Some areas are still blurry. The CSRC has articulated in the consultation draft of the Guidelines that they have adopted principles of “gradual opening-up, limited participation and manageable risk” when designing the scheme for QFIIs to trade SIFs. Moreover, if we compare the Guidelines with the Guidelines for Securities Companies' Participation in Stock Index Futures Trading (证券公司参与股指期货交易指引) and the Guidelines for Securities Investment Funds' Participation in Stock Index Futures Trading (证券投资基金参与股指期货交易指引), we would find that the restrictions on QFIIs are not greater than those on domestic securities firms and securities investment funds. It would be expected that Chinese regulators will further open up the market to QFIIs if the SIFs market develops well with the participation of QFIIs under the Guidelines.

Andrew Zhang and Richard Guo, Fangda Partners, Shanghai