Evolution tipped in China treasury bond futures

Low trading volume for China’s restarted treasury bond futures market should not be seen as a barometer of future demand, says Beijing-based brokerage Galaxy Futures.

China officially relaunched futures in government bonds on September 6 this year after a scandal shut the market down almost two decades ago. To retest the water, a cautious Beijing began a pilot mock-trading scheme in February last year. 

As China liberalises its interest rate, there will be an increasing need for investors to manage the corresponding rise in interest-rate volatility. This also provides investors with a tool to express their directional views on domestic rates and the bond market.

However, the market has received a lukewarm response from investors. On the first day of trading an encouraging 36,635 futures contracts were exchanged. Just a week later this volume had fallen to a daily average of 5,000 and by the week of November 4 this had dropped to 2,884.

Some argue the lack of volume will make it difficult for the market to gain momentum. At present the largest holders of government bonds – banks (69% of the market) and insurance firms (4%) – are not allowed to trade in treasury bond futures.

This raises the prospect of a cash bond squeeze. Securities firms are allowed to trade but do not hold a lot of treasury bonds. Without the largest holders of these instruments, there might not be sufficient cash bonds in the market at this early stage to meet the needs of delivery.

Market size is another worry. But Yao Guang, general manager of Galaxy Securities, prefers to focus on the positives, noting that the market is still in a development stage. “Demand for treasury bond futures [will rise] step by step,” he tells AsianInvestor. “I think two years is a reasonable time-frame.”

He points out that even if banks and insurers are allowed to trade, there is still a lot of groundwork to be covered. “Apart from policy permission, institutions have to build up essential infrastructure,” Yao says.

This includes setting up an appropriate risk-control system, implementing a treasury bond trading platform and hiring the required personnel.

Once infrastructure is in place, market players will still have to adapt to the new system and eventually develop product ideas, which takes time.

“Institutional investors will step into the treasury bond futures market after they have established the demand on products, risk control and hiring,” Yao says.

Ultimately, progress on China’s government bond futures depends on its derivatives market, which is underdeveloped. The only financial futures available currently are CSI300 and treasury bond futures.

“We need to have over-the-counter [OTC] derivatives and options,” Yao suggests. “These tools can help investors to produce personalised investment products to achieve their investment needs.”

Nevertheless, Chinese state-owned enterprises, private banks and qualified foreign institutional investors (QFIIs) are reportedly preparing to begin trading in treasury bond futures, according to media reports.

The understanding is that as interest-rate volatility rises, demand for these futures will increase as institutions look to hedge their interest-rate risk.

China’s treasury bond futures market was shut in 1995 following a scandal known as the “327 incident” that threatened China’s entire financial system.

At that time the underlying bonds were paying over 9%. But with inflation peaking above 22%, speculation mounted that the finance ministry would compensate holders of treasury bonds. That triggered investors to build up long and short positions.

On February 23, the last day of trading for the March 27 futures contract – the code number 327 was used – the ministry announced it would raise rates to subsidise government bond holders.

Wanguo Securities was the biggest short-seller, and therefore the biggest loser. Minutes before market close it tried to rig prices by selling a total of Rmb210 billion in these 327 contracts that did not have sufficient margin deposits.

The Shanghai Stock Exchange subsequently cancelled transactions made in the last seven minutes of trading. Wanguo suffered a loss of Rmb560 billion, was declared bankrupt and was merged with Shenyin. The government shut its bond futures market two months later.