Letter From Shanghai No 960 - The CSRC Opens Chinese Commodity Futures Contracts Via The QFII Route

On Friday evening, following the close, the four Chinese commodity exchanges, to the surprise of the market, issued a series of notices as to which onshore futures contracts are now approved by the China Securities Regulatory Commission (CSRC) for trade by offshore Qualified Foreign Institutional Investors (QFII). The list is extensive and includes

DCE:

Palm Oil*, Iron Ore*, Soybean Meal, Polyethylene, Soybean Oil, Soybean No1, Soybean No2

ZCE:

PTA*, Methanol, White Sugar, Rapeseed Oil, Polyester Staple Fiber

SHFE:

Steel Rebar, Silver, Hot Rolled Coil, Aluminum, Zinc, Copper, Gold

INE:

Crude Oil*, TSR20*, Low Sulfur Fuel Oil*, Bonded Copper*

CFFEX:

CSI 300 Index, CSI 500 Index , SSE 50 Index, CSI 1000 Index

To be fair, the CFFEX equity indices had already been approved under the QFII program but are added here for completeness.

The contracts above marked with a * are those currently offered by BANDS Financial via the Overseas Intermediary (OI) mechanism. An Overseas Intermediary is an approved foreign futures broker who can facilitate foreign investors to trade through to the designated mainland futures contracts. Using the Overseas Intermediary route resolved the issues that had, up to this point, suppressed the development of trading Chinese futures internationally. However, the number of contracts offered via OI is small and now somewhat dwarfed by the contracts that will be available through the QFII route.

Fang Xinghai, vice chairman of the China Securities Regulatory Commission, on August 26, in his opening address to the 19th Shanghai Derivatives Market Forum, perhaps foreshadowed Friday’s announcement when he said that he will

“unswervingly promote the high-level opening of the futures market; promote the all-around institutional opening of markets, institutions and products, and actively explore diversified openings. Implement the national strategy; promote the inclusion of oil futures options in specific varieties open to the outside world, introduce foreign traders to participate, and enhance the international influence of my country’s oil and oil futures prices; promote the two-way opening of national debt and stock index futures; complete all preparations as soon as possible for QFII\RQFII to participate in commodity futures, commodity options and stock index options products, providing overseas traders with more abundant risk management tools.”

In rereading the above statement, although he mentions QFII by name, it is important to note he does not exclude anything. Indeed, one might say as China’s economy slows down, there is an increasing urgency to arrest that decline, and following a period where Covid may have diverted policy attention, government departments and regional officials are now under increasing pressure to show progress, which one might sense in the tone of the above statement.

As the exchange announcement was only published on Friday after the close of the Chinese exchanges, we have no information as yet on the detailed implementation, including whether any delivery mechanism will be available. We are in the process of gathering more detailed information and will update this note when we have it.

However, I think I should try to clarify a few points as to what QFII is and, more importantly, what it is not.

The Qualified Foreign Institutional Investor program was introduced by the People’s Republic of China in 2002 to provide foreign institutional investors with the ability to trade on the Shanghai and Shenzhen stock exchanges. Following several iterations that have lowered the entry boundaries, the program has now been extended to include the commodity contracts above.

I do not have the current list of prequalifications a company must have before it can apply for a QFII licence, money under management, years of operation, etc., but rest assured it must have a Fund Management licence or regulatory approval to be a fund manager in its home jurisdiction. So whereas a Blackrock may have a QFII licence, an oil major or a soya bean producer who wishes to conduct a hedging program on the Chinese exchanges will not get a licence and will be excluded from the QFII route.

Clearly, QFIIs should have the opportunity to trade the Chinese commodity markets for their account, but opening the market to financial players while limiting access via the OI route will only create a strong demand for non-exchange swaps issued by QFIIs in those contracts the OI route does not currently offer. On a regulatory basis, the exchanges can only” see” the QFII and not the economic beneficial owner, the swap owner, beyond the QFII. Therefore, several gaps in regulatory oversight begin to take shape.

For example, the exchanges could no longer see “wash trades.” If a single client used two QFII counterparts as the beneficial owner of the swap contracts, he could create a series of wash trades from QFII A to QFII B, which would be undetectable by the exchanges.

More seriously, using QFII counterparts, a single entity could build up aggressive and sizeable positions that the exchange would not see. As you are aware, in 2021, Archegos Capital Management built up huge positions in a small number of US stocks by buying non-deliverable non-exchange swap contracts through several banks. The firm’s use of total return swaps had helped it to hide its high exposure from its lending banks and the stock exchange. When the price of these stocks fell, Archegos was unable to meet its margin calls, and its positions were unwound at steep losses. The Wall Street Journal reported that Archegos lost USD 8 billion in 10 days, and the losses were borne by the participating banks. This issue was in part replicated in 2022 when Tsingshan, facilitated by several banks, was able to build up a market-defining 180,000 ton short in nickel using OTC swaps, of which the LME Exchange was completely unaware. The closure of the LME nickel contract, the resulting court cases and the losses involved currently haunt the LME as we wait for a resolution.

Aware of the above points, on May 13, 2022, the China Futures Market Monitoring Center (“CFMMC”) issued the “Letter for Amendments to the Relevant Operational Guidelines for Account Opening Services and the Operational Guidelines for Account Opening Services for Special Institutional Clients” in which QFIIs are required to sign an “Undertaking Letter” that requires the QFII to acknowledge

“a QFII that trades in domestic commodity futures, options or stock index options is explicitly restricted from carrying out overseas structured products business or cross-border derivatives business that is linked to domestic commodity futures, options or stock index options.”

It would seem, therefore, that the route for a QFII to offer structured products or swaps to offshore clients based on Chinese domestic pricing is closed.

While the larger group of commodity contracts will open up to fund managers via the QFII route, at the same time, the international industrial clients such as miners, producers, merchants and consumers are not able to reach the same set of contracts.

So here is the point. Opening the QFII route alone does not help China become the pricing benchmark in Asia or globally. The QFII route excludes all international industrial clients such as miners, producers, merchants and consumers who might settle their contracts using the Chinese exchanges and whose participation is vital in creating the internationalization of Chinese benchmarks.

During the 19th Shanghai Derivatives Market Forum, Tian Xiangyang, chairman of the Shanghai Futures Exchange, stated

“Supply and demand in the Chinese market should be better reflected in the global pricing system.”

Therefore I must reply if China wants to be the Asian pricing benchmark, then it must open the same set of contracts to trade and industry users via the OI route.

As I said earlier, many of the points I have raised in this note will be clarified in the coming weeks, and I hope to keep you updated.

I have included the links to the official English language exchange announcements below:

DCE:

https://www.dce.com.cn/DCE/TradingClearing/Exchange%20Notice/8513607/index.html

https://www.dce.com.cn/DCE/TradingClearing/Exchange%20Notice/8513605/index.html

ZCE:

https://english.czce.com.cn/enportal/News/Announcements/webinfo/2022/09/1655821721286599.htm

https://english.czce.com.cn/enportal/News/Announcements/webinfo/2022/09/1655821721132453.htm

INE:

https://www.ine.cn/en/news/notice/6191.html

https://www.ine.cn/en/news/notice/6192.html

SHFE:

https://www.shfe.com.cn/en/AnnouncementandNews/SHFEAnnouncement/911342032.html

https://www.shfe.com.cn/en/AnnouncementandNews/SHFEAnnouncement/911342034.html

Let me know if you have any particular questions. My colleagues and I will do our best to source the answers as soon as possible.

Have a good day,

John