CHINA FINANCE: FUELING MARKET OPENING-UP THROUGH CRUDE OIL FUTURES

Updated on May 21,2014

May 21, 2014

By Yang Maijun, Chairman of Board of Directors of the SHFE

The 3rd Plenary Session of the 18th CPC Central Committee put forward the guidelines of “bringing off the market’s decisive role in resources allocation”, “perfecting the multi-level capital market”, “encouraging financial innovation and diversifying the layers and products of the financial market”, and “promoting the two-way opening-up of the capital market”. These can be interpreted as: price is a major method for resources allocation in the market, and only the price that reflects the supply and demand can guide the rational flow of resources, which, in light of the futures market’s price-finding function, presents a crucial idea of providing forecasting service to the real economy. Only by providing domestic and overseas investors with a convenient and efficient trading platform to centralize transactions and reflect supply and demand can the basic function of price-finding be realized, the optimized allocation of resources be guided, risk management tools be provided to hedgers, and good services be offered for the real economy.

Such guidelines made at the 3rd Plenary Session made clear how China’s capital market better serve the real economy and also pointed out the direction of the futures market’s future development. On May 9, 2014, the State Council released the “Opinions on Further Promoting the Sound Development of Capital Market” (the “9 Opinions” for short), in which it requires to promote the futures market’s construction, develop the commodity futures market, and keep launching bulk resources futures products in order to implement the requirements put forward at the 18th CPC National Congress and the 2nd and 3rd Plenary Sessions of the 18th CPC Central Committee. The release of the “9 Opinions” has offered more space for the accelerated development of the futures market and according to its requirements, the Shanghai Futures Exchange (SHFE) will, by taking the listing of crude oil futures as a breakthrough, speed up the internationalization of listed products and the diversification of market participants, accelerate the opening-up of the SHFE step by step, and enhance the market’s overall capacity of serving the real enterprises and the national economy.

Promoting the reform through opening-up and accelerating the market’s internationalization is the innate demand of the reform and development of China’s futures market.

After decades’ standardized development, China’s futures market has begun to take shape and built a set of relatively mature market operation systems in legal institution, regulation, risk control, brokerage, and talent reserve, thus having been equipped with increasingly mature subjective and objective conditions.

First, take the SHFE for example, it has maintained an orderly market operation and achieved steady growth in trading scale in recent years. In 2009, the SHFE entered into the top 10 derivatives exchanges in the world. In 2013, its trading scale increased greatly compared with that in 2012 and, according to the calculation on a single side, its total turnover reached RMB60.42 trillion, up by 35.47% year-on-year, and its total trading volume was 642 million contracts, up by 75.86% year-on-year. Statistics from the Futures Industry Association (FIA) of the US show that the SHFE’s total turnover in 2013 ranked the 4th among all commodity futures and options exchanges and the 1st among all commodity futures exchanges in the world.

Second, with the steady growth of the trading scale and the increasingly strong market basis, large numbers of industrial clients and spot enterprises have participated in the futures market dominated by the SHFE’s nonferrous metals products to conduct hedging and to manage prick risks in the real economy. As a result, enterprises’ daily operation has become closely related to the futures market, and the trading and delivery mechanisms of the futures market have also been closely linked to the operation practice in spot market. Under the backdrop of the market’s steady development, only by focusing on making the domestic futures market bigger and stronger can the SHFE better serve China’s real enterprises in more fields and play positive roles in escorting the real economy in the opening-up process.

Third, after years of development and education, the SHFE’s futures products have been increasingly mature and its price influence has been increased continuously. Take copper as an example, the SHFE has become the 2nd largest copper futures trading center in the world; its nonferrous metals futures market, led by copper, has accumulated abundant market resources; and it has diversified customer groups, including domestic real enterprises and a group of international enterprises with legal persons registered in China. It can be learnt through the communication with large numbers of international real enterprises and investment institutions that only the futures market with solid spot industry basis, active trading, sufficient liquidity, and price depth is a “magnet” for them.

It can thus be seen that only by accelerating the opening-up of existing products, attracting overseas investors’ participation, and promoting the close interaction between domestic and foreign markets can the futures prices be really promoted to play larger roles in international trade pattern and global resources allocation. Under such circumstance, the SHFE has begun to explore the road toward opening-up and internationalization. In November 2013, the SHFE, led by the China Securities Regulatory Commission (CSRC), has officially registered and founded the Shanghai International Energy Exchange at China (Shanghai) Pilot Free Trade Zone (FTZ). It has launched the exploration in market openness through piloting crude oil futures, and it will choose the right time to apply the opening-up policy and successful experience to other existing products, so as to positively facilitate the internationalization of the SHFE and even the domestic futures market.

Making a key step further for the opening-up of the futures market with crude oil futures as the breakthrough

The launching of crude oil futures is of great significance to safeguard the security of the national energy.

Building the crude oil futures market is an important measure for China to safeguard the strategic security of national petroleum and to guarantee the petroleum market’s stability. In 2013, China produced 208 million tons crude oil, imported 282 million tons, and consumed 490 million tons, with 57.4% degree of dependence on import. As China is the 5th largest petroleum production country and the 2nd largest petroleum consumption and import country in the world, the fluctuation of international oil prices will have great influence on China’s macro-economy and petroleum-related industries. Due to the lack of domestic crude oil futures market, China’s import crude oil prices are mainly referred to those of the New York Mercantile Exchange’s West Texas Intermediate (WTI) and Intercontinental Exchange’s Brent crude oil futures. However, the prices of these two crude oil futures markets can hardly reflect the supply and demand situation in China’s market objectively.

From the international scope, the crude oil market is one of the commodity markets with the largest trade volume and the longest transportation distance in the world, with numerous national petroleum companies, transnational petroleum companies, petroleum trading companies, and individual oil refineries involved. However, from the national scope, the crude oil spot market is largely a relatively monopolized market with either the national petroleum company taking the dominant position or the transnational petroleum company oligarch conducting segment monopoly, thus lacking market participants. All these are caused by the natural monopoly characteristic of the petroleum market and are also the demands of the strategic powers in maintaining national petroleum security.

At present, China National Petroleum Corporation and Sinopec Group are the only companies in China that have an integral industry chain covering both the upstream and downstream and the domestic and foreign trading and that have independent crude oil production, refining, and import and export qualifications. The industry chains of other crude oil production, refining, and import and export enterprises all present deficiency of certain degree. Though China has fully implemented its promise in its WTO accession, its domestic crude oil spot market still lacks market participants. Therefore, China’s crude oil futures market should be constructed by centering on the crude oil market in Asian-pacific region and even in the world, so as to create better conditions to attract the participation of overseas investors.

Basic thoughts of designing crude oil futures market

Given the international crude oil spot market’s features of lack of competition inside a country and the free competition in international trade, the SHFE has set up the basic principle of “establishing an international platform for net trading and bonded delivery” with regard to crude oil futures products.

More specifically, the “international platform” involves internationalized trading, delivery, and clearing which will bring convenience for domestic and overseas investors to participate freely, efficiently, and conveniently. Besides, the SHFE will rely on the international crude oil spot market and introduce the domestic and foreign investors, including transnational petroleum companies, crude oil traders, and investment banks, so as to break the domestic spot market’s predicament of insufficient market participants and constrained crude oil circulation and to bring off its roles in reflecting the petroleum supply and demand situation in the China and Asian-pacific time zones and in winning Chinese petroleum pricing influence by utilizing standards and regulations.

The “net trading” is to value by the net price with no tariffs and value-added tax, which differs from the current tax-inclusive prices for all domestic futures trading and will be convenient for it to be compared with the tax-exclusive prices in the international market.

The “bonded delivery” is to conduct physical delivery relying on bonded oil depot. The valuing of bonded spot trading is the net price, as the bonded trading will exert little restriction on participants and the bonded oil depot can be regarded as a link to connect domestic and overseas crude oil markets, which will help international crude oil spot and futures traders to participate in trading and delivery, and eventually form a distributing center and pricing benchmark for crude oil trading.

Introducing overseas investors as the core of launching crude oil futures

Under the premise of making clear the basic idea of crude oil futures, the SHFE has already completed such preparatory work in the preliminary design of the regulation system, the establishment of key technical systems, the marketing, and the international business and, in particular, it has strictly adhered to the domestic regulatory systems of “one client, one code”, position-holding limit, and report of big client which have been proved effective by practices. Besides, a set of operational process for crude oil futures trading has been set up. The SHFE will fully pre-evaluate market risks and carefully design the trading operation system, so as to ensure that the market operation will be stable and the risks measurable, controllable, and bearable after the listing of crude oil futures.

The core of launching crude oil futures products is to fully introduce overseas investors to participate in domestic futures market, which will pose the demands to make breakthroughs in relevant policies in foreign exchange and tax revenue and to improve the law and regularity system. Considering the characteristics of the crude oil spot market, introducing overseas investors’ participation will be of key significance to the success of China’s crude oil futures. In order to list crude oil futures as soon as possible, a supporting management measure that conforms to international practice with simple operational process, low trading cost, and certain attractiveness should be set up in terms of market access and regulation, capital allocation and conversion, tax collection, and the custom supervision for bonded goods.

Currently, the supply and demand pattern of the international petroleum market is undergoing profound adjustment and the consumption focus is further shifted to Asian-pacific region. However, the crude oil futures prices of the United States and Britain can hardly reflect the supply and demand situation in China’s market objectively. In face of the strategic opportunity of building an Asian-pacific crude oil pricing center, Japan, India, the United Arab Emirates, and other countries have launched crude oil futures in succession; Chicago Mercantile Exchange has become a shareholder of Dubai Mercantile Exchange; and the International Securities Exchange has recently purchased the Singapore Commodity Exchange. All these have exerted inestimable influence on Asian-pacific market, and China should seize the current opportunity and list the crude oil futures as soon as possible. The listing of crude oil futures will undoubtedly explore valuable experience in market operation and regulation for the internationalization and full opening-up of China’s futures market and accumulate practical experience for China to get pricing right in bulk commodity trading.

Combining the breakthrough at key points and the promotion in an all round way to promote the SHFE’s internationalized development

The crude oil futures should be promoted at the opportunity of building the FTZ, the strategic significance of which is to establish an international trading and settling platform by fully utilizing the FTZ’s opening-up and pioneering international environment, so as to boost the construction of the FTZ and the international financial center, as well as the internationalized progress of the RMB. Meanwhile, the SHFE will pilot the crude oil futures and focus on the “self-oriented” principle to apply its opening-up policy and successful experience to other existing products.

First, the SHFE has strived for relevant opening-up policies from related ministries and commissions in terms of foreign exchange, customs, finance and tax, and commerce, in hope of laying a solid policy condition for promoting the futures market’s internationalization progress. In September 2013, the CSRC released five measures for the capital market to support and promote the construction of the FTZ and made further research to detail relevant policy measures. The People’s Bank of China has also released relevant opinions on supporting the FTZ construction recently and focused on facilitating the reform and pilot in such fields as the cross-border use of RMB, the conversion of RMB capital projects, the interest rate marketization, and the foreign exchange management. Along with the promoting of crude oil futures, the SHFE will actively make use of the FTZ’s supporting opening-up policies in customs, foreign exchange, commerce, and tax to attract the direct participation of overseas investors and vigorously enhance the internationalization level of the futures market.

Next, building the crude oil futures market can accumulate experience for the internationalized development of the futures market. The first is to lay a policy basis for the full internationalization of the futures market, such as the access and regulation policy, the tax collection and management policy, the foreign exchange management policy, and the customs policy of bonded regulation which will be involved by overseas investors. The second is to accumulate regulatory experience, as perfect transnational regulation will greatly enhance international investors’ confidence in participating in China’s futures market and will help to maintain market order and to control and resolve market risks. The third is to provide domestic futures companies and investors with advanced management experience and the experience in business pattern, trading, operation, and risk control, thus increasing the domestic futures market’s capacity of serving the national economy on the whole.

Finally, the SHFE will make use of the policy measures and pilot experience of crude oil futures to promote its shift from a domestic market toward an international market and meanwhile accelerate its internationalized development by sticking to the “self-oriented” principle in the opening-up process. The “self-oriented” principle has two meanings: the first is to base on making the domestic futures market bigger and stronger and to attract overseas investors to directly participate in the SHFE through the “ushering-in” strategy; and the second is to center on the domestic futures market rules and to maintain the existing fundamental trading, delivery, and risk control modes. Under the abovementioned principles, the SHFE will choose the products with better market function display and with higher level of marketization and internationalization and usher overseas investors in the domestic futures market. Specifically, work in the following aspects should be well done:

The first is to continue to expand the coverage of “bonded delivery” and increase the international influence of “Shanghai prices”. The SHFE launched the pilot in copper and aluminum bonded delivery in 2010. Since then, the bonded delivery business has operated smoothly and present stable function display. In 2013, the General Administration of Customs officially approved to expand the bonded deliver products to other futures products apart from copper and aluminum and to extend the bonded area to the FTZ.

The second is to “formulate standards” and “export standards” through promoting foreign brand’s registration in China to increase the global position of “China Standards”. At present, over 20 foreign copper brands, including Chilean Copper and BHP Billiton Ltd., have successfully registered at the SHFE, taking up about 50% of the total foreign copper yield.

The third is to, under the leadership and support of the CSRC, take advantage of the good opportunity of gradually opening the capital projects to research the way and method of deepening the cooperation with overseas futures markets, so as to effectively facilitate the “ushering-in” and “going-out” double-way internationalization of the domestic futures market.

The fourth is to, in accordance with the arrangement of the regulatory institutions and such international standards as the Principles for Financial Market Infrastructure (PFMI), complete internal evaluation, receive external assessment, and enhance its operational level in line with international standards.

And the fifth is to serve the market and develop clients by holding such high-end international activities as the Shanghai Derivatives Market Forum and the Asia Copper Week. The SHFE will also keep strengthening efforts on training and introducing international talents so as to prepare enough reserve of talents for the all-round opening-up of the market.