The Chinese commodities derivatives market has grown at a rapid pace in the recent past. Today, Chinese exchanges are among the top five globally. Out of the top 15 futures contracts in the world, nine are traded on Chinese exchanges. A recent field study on the Chinese market offers several interesting insights about its growth dynamics.

First, while China has significant pricing power in many commodities on account of its share of demand or supply, the role of its vast retail trader base that allows it to build market volume often goes unnoticed. The volumes contributed by retail traders are typically 50-95 per cent with several factors driving the retail excitement.

Primarily, there is a widespread belief among retail traders that China controls price-sensitive information of many commodities and, therefore, they would be able to trade profitably. The retail excitement is also contributed by the repression of their participation in stock market volatility through individual stock derivatives.

Further, contracts traded in China suit the retail appetite with smaller lot sizes. The lot sizes are only a fraction of that employed in the international exchanges. The retail trading has also been aided by high leverage through grey market loans and online borrowing.

Second, the Chinese commodities market operations are strongly cost-competitive through efficient warehousing, delivery arrangements, and the integration of technology. The round-trip cost of non-delivery based proprietary trading in non-agricultural commodities is in the range of 31-99 per cent of the cost of trading the same commodity in India.

A major factor that lowers the transaction costs is the absence of CTT (Commodity Transaction Tax) in China. Also, the financing of commodities market is facilitated by efficient linkage between warehouses and banks, including the use of fintech to ensure the integrity of warehouse receipts.

Third, the explosive market growth has also been aided by several regulatory measures aimed at limiting the destabilising impact of excessive speculation. The Chinese market imposes a higher degree of time-varying margin which steeply rises as a contract approaches maturity.

There are also multi-level price limits during the delivery months. Moreover, unlike other major markets, retail participation is prohibited in the delivery month. The combination of time-varying margins along with position restrictions and price limits disincentivise retail traders from holding near delivery contracts.

These regulatory interventions prevent excess volatility build-up and ensure relatively smooth functioning of the commodities market.

Fourth, the success of the commodities market is also strongly driven by many successful product launches. China only launches products that are strongly linked to its underlying industrial sectors.

It builds market depth through partnership with futures brokers, who aggressively push the products among retail traders. Rigorous research is undertaken on new product opportunities and their potential market.

Finally, the risk management needs of Chinese firms are mostly met within the domestic market through restrictions on the state-owned and private enterprises in hedging in international markets.

Valuable insights

The growth experience of Chinese commodities markets offers several valuable insights for the development of derivative markets elsewhere in the world, including in India.

Launch of new products: The launch of new derivative products should be strongly linked to the underlying industrial sectors. Such a product match strongly helps to build trader attention, driven by the belief of their information advantage. The futures brokers can play a key role in the launch of products. They could act as a bridge to ascertain market demand at the pre-launch phase as well as during the market development phase.

The future brokers need to be incentivised by exchanges as part of the market development programme. Markets like India should set up a common funding pool for market development of new products through systematic contributions from the market infrastructure institutions.

The Chinese exchanges do not compete for order flow by launching products on the same underlying. It shows that specialisation avoids fractionation of order flows and improves the price efficiency of the market. A valued experiment from China is the tie-up of the futures brokers and insurance companies to help farmers to manage the price risk of farm produce. Farmers and farmer cooperatives in other countries could replicate similar arrangements for commodities largely produced by small and marginal farmers.

Liquidity enhancement through greater retail participation: The Chinese experience suggests that smaller contracts can be offered at lower overall transaction costs aided by their higher liquidity and larger delivery lot size. The larger lot size lowers the cost of participation while matching with the delivery needs in the physical market. Therefore, it would be valuable for countries like India to examine whether it can offer smaller contracts targeted to retail to enhance market liquidity, without adversely impacting the transaction costs.

Cost of operations: This needs to become competitive for market success. The Chinese market does not have CTT, it has more efficient warehouse operations, and faces relatively lower margins. For instance, the Dalian Commodity Exchange has a margin of only 5 per cent until the 15th day of the near month, which then increases to 10 per cent for the remainder of the month. In comparison, the initial margins for most commodities in India are 8-10 per cent. The experience shows that lower margins can be successfully supplemented with more frequent interventions.

Regulatory changes: The restrictions on domestic firms from hedging in international markets amount to a penalty for the hedgers until sufficient liquidity is developed in the market for products of their choice. However, the Chinese experience shows that state-support to firms until the market reaches sufficient liquidity for their hedging needs eventually creates domestic demand for hedging.

Other countries may want to encourage their small and medium segment firms to actively hedge their risk in the domestic market through indirect incentives.

The writer is Associate Professor, Accounting and Finance, at IIM Ahmedabad. Views are personal

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