News flow is often a useful barometer of a market's development and on that basis China is 'set fair'. Just the first two weeks of August saw a raft of announcements ranging from exchange fee and commission reductions, to the launch of new products, to exchange guidance on the development of fund products.
Innovation and education
This news flow is backed by substantive progress in terms of trading infrastructure and instruments. At present, much of the activity is taking place in the derivatives space, with one of the hottest topics being the projected launch by the Shanghai Futures Exchange of a crude oil future. For a country with oil consumption on the scale of China this would be significant anyway, as current discussions suggest that it will be the first Chinese futures contract that will be readily accessible to overseas investors. However, a further incentive for traders is that the contract may be listed in renminbi rather than US dollars. While on the subject of currency, the Hong Kong Exchange (HKEx) has also announced the launch of a renminbi futures contract, which will add further liquidity to the offshore renminbi market.
There is further innovation underway in financial as well as commodity contracts. The China Financial Futures Exchange (CFFEX) has launched the CFI 300, which is an index future on the top 300 Chinese stocks with average daily volume already in excess of one million contracts. The exchange is additionally considering the possibility of launching a CFI 50 index future plus a long bond futures contract.
At present, options are not authorised for trading in China by the regulator. Nevertheless, all the exchanges are making preparations for them on the assumption that these will eventually be authorised, though possibly not until 2013 or 2014 at the earliest. Options on individual equities plus on futures contracts are both possibilities, so exchanges and leading brokers are developing test systems and APIs that include these.
The current absence of options in Chinese markets has left a knowledge gap that various parties are working hard to bridge. Numerous Chinese brokers are travelling to the US for training on options, while European exchanges such as Eurex are also providing option training. Although overseas exchanges are not allowed to market any of their products in China, the demand for options training is proving a convenient way of building up relationships for the future.
Finally, it is worth noting how the pace of innovation within China also links to a global perspective, firstly through onshore trading by non-domestic entities, but also through China's direct involvement in overseas markets. Examples include the acquisition of the London Metal Exchange (LME) by HKEx, Bank of China applying for LME and CME membership, and numerous other Chinese brokers applying for non-clearing membership of Western exchanges (which will probably over time become clearing memberships).
Trading into China
The opportunity presented by Chinese markets to overseas traders is immediately actionable because the legal mechanism for them to trade onshore already exists. The Wholly Foreign Owned Entity (WFOE) can be used by international companies to establish a 100 percent owned trading subsidiary in China for trading Chinese markets. The WFOE is set up as a physical commodity trading company, which as a result is also permitted to trade commodity futures contracts. The WFOE can therefore simply open an account with a Chinese broker (of which there are some 120 operating on the country's futures exchanges) in order to obtain market access.
Figure 1: The RTS global network
Attractive as China's markets are, it is essential for overseas trading firms to appreciate that they operate in a very different manner to most Western markets. One fundamental point is that in China algorithmic trading definitely does not equal high-frequency trading. One issue is that exchange trading platforms do not have any facility for order change transactions (or where they do, it is not yet approved by the regulator). Therefore changing price or quantity involves cancelling the entire order and the submission of a new one, which obviously results in loss of queue position.
Another challenge is that exchanges enforce transaction limits - for example, until recently the maximum number of order cancellations permitted in a day was 500 and this has only recently risen to 1000, which clearly makes high frequency trading (or even Western-style spread trading) impossible. This means that standard spread trading software commonly used in Western markets simply cannot work in China. Frictional costs are another obstacle to scalping, or other trading styles that only attempt to capture a few ticks. Despite recent changes, both exchange fees and broker commissions are currently at levels well above those seen in the West.
There is also the matter of market data, which in China is transmitted as snapshots, not continuously streamed. Data snapshots are only distributed twice per second and only provide Level I; there is no Level II data. While this obviously makes high frequency trading non-viable, there will be those in the West who will look upon this as a major opportunity, because it will give them new markets in which to trade that will not be affected in any way by high-frequency traders for some time to come.
The bottom line is that overseas trading firms looking to move into China need a different sort of trading technology. This needs to be sufficiently flexible to allow the development of trading strategies that are viable for China, rather than just re-applying existing 'Western strategies' that simply won't work. In many cases, these 'China strategies' will involve longer time horizons and either directional trend following strategies, or longer term arbitrage strategies against markets outside China.
This latter opportunity is particularly significant given the rapid emergence of new markets/instruments in China, but realising it to best advantage requires a technology partner with an exceptional footprint in terms of market access. More specifically, it ideally requires a provider that not only accesses the widest possible range of relevant markets outside China, but that also has direct connectivity into SFIT (see Figure 1). This is the technology arm of the Shanghai Futures Exchange that operates co-location facilities in Shanghai in which the leading Chinese brokers have rack space. The reason that this is important is because Chinese exchanges are connected on a single fibre ring, into which SFIT connects. Therefore a broker with a presence in SFIT's co-location facility has efficient and cost-effective one stop connectivity to all Chinese exchanges.
Trading within/out of China
Chinese companies trading their own markets have many of the same requirements as overseas traders, but they also have some specific needs. While many of them trade outright futures contracts, there is also demand for inter-month (calendar) spreading and handling of rollover dates. However, at present the exchanges do not have the facility for trading spreads as single orders, so each leg has to be executed separately. There is, therefore, huge demand from traders for the technology to build algorithms for automatically trading or making markets in calendar spreads to avoid legging risks.
Similar demand is apparent from brokers wishing to use the same technology to build calendar spreading algorithms that they can offer to their clients. These brokers are also looking for more sophisticated trading technology to either build execution algorithms to offer their customers, or to provide a framework/toolkit to their customers so they can build their own algorithms and strategies that can be deployed within China, outside China, or both. This last point is significant given that there are now six mainland Chinese brokers with Hong Kong subsidiaries that have licenses permitting Chinese retail or institutional clients to open accounts for offshore trading. Many of these clients are already trading overseas commodity markets (both outright and as spreads) using automated and/or systematic strategies - hence there is considerable prior demand for more sophisticated trading technology that has global execution capability.
Another important consideration is language: any such trading technology must be capable of multilingual display, including both traditional and simplified Mandarin (see Figure 2). Furthermore, technology vendors also need to employ local personnel in order to provide appropriate support. This will only become more important as trading businesses within China grow in both number and size. This is already starting to happen as Chinese nationals who have been trading in the US, London or Singapore have spotted the domestic opportunity and are moving back to China to open their own trading entities. At present, these enterprises are relatively small but they are likely to evolve over time in the same way as in the West by hiring and training college graduates to build substantial trading arcades.
Figure 2: RTD Tango Trader multilingual interface
At present, Western markets are extremely competitive, liquidity is in many cases thin and profitable opportunities are scarce. By contrast, China looks far more promising, with liquidity building quickly (even in relatively new contracts), the marketplace expanding, and enormous long-term potential. Furthermore, while much of the current focus is on futures exchanges, their equity counterparts such as the Shanghai and Shenzhen stock exchanges are also important and growing players.
While China's financial market evolution will not happen overnight, there is much to be said for early adoption. As outlined above, China differs significantly from Western markets and addressing these differences is essential for profitability. Those Western trading firms who start now and treat China as a long-term investment will enjoy a substantial competitive edge over their peers who arrive later. Ultimately, participation in China may one day no longer just be a matter of P&L, but one of survival.