EC: How will the growth of derivatives contribute to the development of the financial markets in China?

Peter Zhang, Shanghai Futures Exchange: There is still a long way to go to promote derivatives. Even in the US it has taken years for the whole market to accept options since they started in 1973. Now for China this process will be quicker in this day of the information age.

Dewey Yee, Risk Portfolio Management: Many people can gain from a thriving derivatives market in China. As we know derivatives not only help increase yield but also manage risks. As China's financial markets open many expect China to surge forward to keep up with other developing countries.

Zhang Lei, CFETS: Many financial institutions, companies, and some individuals, possess a considerable amount of foreign exchange, but it is hard to invest it or hedge foreign exchange risks. As interest and exchange rates become more market-driven there is a growing demand for derivatives products. Take the interbank bond market, for example, where the dealing volume in the nine months to September this year reached Rmb8.9 trillion with more than one thousand members.

Peter Zhang, Shanghai Futures Exchange: Since October our daily trading volume has doubled. I believe this year has been the most stable of the twelve years' history of China's futures market. This year the State Council's "Nine Articles" on the Development of Capital Markets produced three derivatives of commodity futures. It is the first time in ten years that there have been new futures products. It started with corn and cotton futures in Zhengzhou, followed by oil futures at the Shanghai Futures Exchange, and corn futures in Dalian. The trading volume of the country's three futures exchanges last year amounted to Rmb10.6 trillion (56% from the Shanghai Futures Exchange), surpassing that of the two local stock exchanges. In the nine months to September this year the trading volume had already surpassed last year's total.

EC: What are the first steps towards building a successful derivatives programme?

Simon Heale, LME: Education, understanding, and communication.

Chen Sheng, CBRC: The most important question for the CBRC is how to educate financial consumers. The regulator often receives complaints from consumers saying they have suffered losses. Rather than go to Court or seek arbitration they seek our support, expecting us to acknowledge the complaint, and punish the bank unilaterally. We are paying close attention to the development of financial derivatives. For example when Citigroup introduced the structural deposit derivative of foreign exchange in Shanghai we regulated that Citigroup must provide an exposure statement on consumers' risks. We also regulated that the statement must be clearly written using big characters and a bold typeface. This way clients can understand each term of the statement including the risks to which they are exposed. We are also considering how to educate consumers further, and by which channels we should let them know of investment risks. If we can get this message across, should losses occur, everything should rely on the contract and be judged according to the contract signed at that time.
Additionally, derivative products are not suitable for all clients. High-risk derivatives with high investment returns should only be sold to those able to withstand the pressure. Investors should be taking legal advice to ensure that they properly understand what they are exposing themselves to. This year we have been highlighting the risks to consumers, letting them know the risks associated with the derivative products in which they have invested. To date we have used newspaper columns, and are considering other channels to let consumers know more about investment returns and risks.

Ivan Wong, HSBC: Education is the most important of the three. It can help financial institutions, companies, and individuals, to understand better the functions and risks of derivatives. Regulators also need to have a deep understanding of the application of derivatives to be able to establish laws and plans advantageous for market development.
The market is made up of hedgers, market makers, investors, and speculators, all of whom play their parts in a healthy market. Suppose the market were only made up of hedgers: were a company to want to hedge one of its risks, it would then have to seek another company with the opposite risk, not forgetting currency code, timing, and so on, to enable the transaction. This could lead to a steep discount. It is the very diversity of the participants in the market that increases the efficiency of the market.

Peter Zhang, Shanghai Futures Exchange: Education is becoming easier than before. When I was working in Japan in 1996 I must have flown to lecture in Shanghai and Beijing more than twenty times. At the time I found it difficult because the products referred to were all American, Japanese, or European. There were few domestic companies listed in Hong Kong in 1996. Now it is definitely better. The Hang Seng Index is a product familiar to the public, although more important are the H-shares index futures set up in Hong Kong last year, followed by H-shares index options this year.

Cheng Chi, CNOOC: I believe demand will open the market of its own accord. Were cotton prices to be floating, while mungbean prices were fixed, there would be no mungbean futures in China. If interest rates were not market-driven, the futures market for interest rates would be meaningless. There can be no doubt that practice always goes before supervision. China's financial markets however are lagging behind those of other developing countries. There must be many case studies from developed countries that we should be drawing upon to apply to the financial markets here.
I agree with Simon that education is the first step, which is to make derivatives clear to the public. No matter how useful the derivative is, healthy development of the market must be the prerequisite. A domestic bank, for example, might have developed a new product, but the salesman is not familiar with the risks hidden within this derivative product. In conclusion it must be a combination of the regulators, banks, and exchanges that will educate consumers

EC: Which derivative classes will prove to be the most popular and why?

Ivan Wong, HSBC: Interest and exchange rate products especially for Rmb-related products. The long-term development of interest rate derivatives of the Rmb is decided by the course of market-led interest rates.

Gu Yu, CCB: I agree with Ivan. In the international markets interest rate products also started first. Looked at from their functions, derivatives can manage financial risks and increase yield. Another benefit of derivatives for China's commercial banks is to provide additional services to clients. CCB, for example, started developing derivatives in the '80s, mainly providing hedging of foreign currency debt and fund management to clients using derivatives. To date commercial banks in China mainly use foreign currency derivative products with hardly any Rmb derivative products. Now that the corporate Rmb bond market has started to emerge, demand for derivatives is much greater.

Miao Junwei, Fortis Haitong: Chinese investors mainly rely on savings to satisfy their need for security as well as a lack of understanding of the risks. A careful look at the financial markets shows that, after currency products, stock investing products instead play vital roles in the markets. (Bond investing products are still too simple because of the undeveloped corporate bond market.) Considering China's interest rate is on its way up at present, and the above products all lack a hedging system, you will find that when investors choose to invest in finance products, there is always a great leap to be made from low-risk savings to new investing vehicles of higher risks.
Structured products based on a hedging system may be the bridge between bank savings and high risk investments. Fund managers realise the market potential of structural products, but without the necessary hedging system nothing is to be done. Take stock index futures, for example: should these be developed as early as possible the whole national economy will benefit from their development.
There are products which are managed by setting risk budgets that minimise speculation. The authorities have become more flexible when it comes to allowing commercial banks to engage in speculation. However when it comes to a successful structural product it is not about speculation but effective use of financial derivatives, and managing the technologies. Forget about improving product yield or controlling and reducing risks. The ultimate target is to develop real products that are clear about the risk structure, definite, and effective.

Cheng Chi, CNOOC: I think the definition "Financial Tools" is much better than "Derivatives". The former definition emphasises it as being a tool for financial risks, but the latter is too easily misinterpreted.

EC: What about mitigating, managing, and diversifying the risks?

Chen Sheng, CBRC: Several foreign banks have been developing structured products in Shanghai. One bank is in the process of being sued since its client made a financial loss from a derivatives product. The client argues that the bank had not explained clearly the risks. The Court is now asking us to certify that we had authorised the bank to do this business. Once derivatives have been developed in China, one can expect a large amount of litigation.

Simon Heale, LME: I believe derivatives are an important tool and are a healthy development for financial markets and I commend the Chinese government's commitment to stable development. Commodities futures derivatives in my opinion are crucial to China's economic development. After commodities futures financial derivatives are the most important. I believe that the management of derivatives transactions is fundamentally different to that of the stock markets so the healthy development of derivatives requires close collaboration between exchanges, regulators and firms. At the heart of it all is the ability to manage risk and that is the key benefit of a well regulated derivative exchange.

EMC: How will the regulators continue to monitor the business?

Chen Sheng, CBRC: The most important regulation for derivatives today is Order One issued by the CBRC on March 1st, 2004, setting out the interim management method of financial institutions' derivatives transaction business. Prior to the creation of the CBRC last year there were some other laws relevant to derivatives. The first was SAFE's management regulation concerning financial institutions' handling of foreign exchange business (issued April 15th, 1993). The second was the PBOC's forbidding of financial institutions from developing outbound derivative transaction businesses (issued March 29th, 1995). The third was SAFE's management regulation concerning financial institutions' handling with near and forward foreign exchange business on behalf of clients (issued March 9th, 1998).
The CBRC emphasises again and again the steady development of the derivatives trade. Non-financial institutions are not allowed to provide derivative products. We are always emphasising that admittance to this market is open to large institutions with relevant experience. There are 112 city commercial banks in China, and none of them have a derivates licence. Only several domestic state commercial banks have the licence for financial derivatives business, along with twenty 20 foreign banks.

EC: What are the responsibilities of the banks?

Gu Yu, CCB: The first and most important responsibility is to master and develop derivatives. Commercial banks are either the end user or dealer. Commercial banks must be familiar with derivatives, and then design each product depending on the client's position. The second is that banks should focus on gaining the trust of their clients, because the design of each product is based on the bank's own estimation of the market.

EC: And what are the responsibilities of the corporates?

Cheng Chi, CNOOC: When FAS 133 first came out concerning financial derivatives we dared not use it. Gradually we came to understand that it was all about reinforcing exposure and supervision. The CBRC should issue rules for accounting for derivatives.

EC: What are the lessons that can be learnt from other markets?

Simon Heale, LME: The LME has not dealt in gold. We tried silver, but not successfully. We considered gold but still decided to quit, because it is more difficult to deal in gold than other products. Firstly, we tend to focus on wholesalers for particular industries. Secondly, most of our clients are central banks. Lastly, and most significantly, over our 200-year history, we have become the trade regulator. Gold transactions are successful in New York and Tokyo, while they have failed in London.

Peter Zhang, Shanghai Futures Exchange: It is really a difficult question to solve the educational and supervisory issues. Even the strict legal system of the US could not solve this problem. For many of the more complex derivatives, salesmen do not know the characters of the derivative. That's why the clients might feel that they have been cheated should a loss occur.

Ivan Wong, HSBC: I would like to ask Simon a question. How do you see the relationship between the OTC and the spot market?

Simon Heale, LME: That is a difficult question. From the viewpoint of the LME the Exchange should come first; but in practice it is the other way round. I think they are actually complementary. If you were to make me choose between the Exchange and OTC, I would go with the Exchange. For example when Enron collapsed all that was left was its metals business. I am really proud of this. Without an exchange I believe it would have been much easier to break the rules.