Remarks by Leo Melamed before the International Advisory Council of China
November 28, 2016
OpenMarkets: Why China Needs Modern Futures Markets
Although futures markets themselves are centuries old, the modern futures model which the financial world centers have adopted began in the 1970s with the introduction of financial futures at CME Group. The most important factor which propelled this success was the technological revolution which ensued almost at the same time.
Technology enabled investment science to uncover the basic components of financial risk. Financial engineers were thus enabled to disaggregate, repackage, and redistribute risks and their corresponding rewards, exchanging one set of risks and rewards for another that responded better to an investors’ preferences.
By the beginning of the 21st century, the creation of the China Securities Regulatory Commission (CSRC) served to establish the following futures markets in China: The Shanghai Futures Exchange, (SHFE), The Dalian Commodity Exchange, (DCE), and the Zhengzhou Commodity Exchange, (ZCE), each restructured with accepted regulations and each trading in a different class of commodities. China’s entry into finance however did not occur until 2006 with launch of the China Financial Futures Exchange, (CFFEX) to trade in the popular Shanghai Stock Index, the CSI 300. The CFFEX was an instant success, with an overwhelming volume from the very first day. In every instance the CME provided assistance and advice in the continued development of these markets.
However, all four Chinese futures markets, while successful, suffer from the same flaw. They are primarily domestic and nearly without any global participation. As the world’s largest importer of many commodities, Chinese futures markets should be playing a major role in global price discovery and they are not. Until Chinese futures markets become subject to cross-border interaction, the full value of futures to the Chinese economy will continue to be limited.
China has entered the transition period for economic growth. Its leaders have instituted a transformation process from an export dependent manufacturing economy to a consumption-driven economy, one powered by internal growth. As this transformation takes place, it is imperative to understand the role of price discovery in commodity and financial markets.
Price discovery is not just about setting fair or reasonable prices at any given point in time. Price discovery goes to the heart of efficient resource allocation over time, including an emphasis on managing the natural volatility of prices. If markets are structured efficiently, which requires a diversity of market participants to enhance the price discovery process, then key feedback loops between price discovery and risk management work together to enhance greatly the way scarce resources are allocated to the benefit of the economic growth process. And China, building on its excellent record of economic growth and modernization, has the opportunity to define its own regulatory structures to build a modern market system that emphasizes efficiency in price discovery, while learning much from the mistakes, layered complexity, and inefficiencies of the regulatory practices in the U.S., Europe, and Japan.
One example is sufficiently instructive. Since in the U.S. we recently celebrated Thanksgiving, I will use turkeys as an example. One may visit a restaurant to consume prepared turkey right then and there. The restaurant, however, had to buy the turkey in advance and store them over a period of time based on expectations of customers ordering turkey dishes from the menu. The poultry farmer had to buy and store food for the turkeys and then raise them, a time consuming process.
There is also the transportation aspect, getting the turkeys from the farm to the processor to the distributor and finally to the restaurant which requires considerable planning, fuel purchases, warehousing costs, etc. We are no longer talking about the price discovery process for turkeys on the restaurant menu at one point in time. We are talking about all the considerable costs of production and the time dimension involved in the whole chain of economic events.
Allowing farmers to sell their crops forward with a locked-in price for future delivery coupled with allowing farmers to buy their feed and fuel with long-term contracts results in better management of financial costs and risks into the future. All of these things make it possible for the farmer to focus on efficient production and allow someone else to worry about future prices of crops, the evolution of energy prices, or financing costs.
Whether we are discussing firms that raise turkeys, process them, transport them, or serve them on the menu, the concept applies generally, whether it is oil, steel, or the British Pound. The existence of a specific price for the management of future price volatility allows the choice of outsourcing the management of these risks as well as the possibility of running the company with less capital due to a smoothing of the expected revenue and earnings stream. The fact that we cannot provide a very good quantitative estimate on the benefits to the economy should in no way obscure or diminish the very real and substantial advantages that can accrue to economic activity.
For instance, Mexico just announced that it is set to earn about $2.9 billion from its oil hedges for 2016, reaping a windfall from plummeting crude prices for a second straight year, according to the International Monetary Fund.
Active participation from a diversity of producers, consumers, and risk-takers are needed to provide robust sources of price discovery. There is also a presumption that information about prices will be transparent. To gain the full benefits of linking spot and forward-looking markets and to ensure robust price discovery process, it is not enough to include diverse market segments, but the regulators must also work to ensure price transparency.
Markets that are not trusted are unlikely to produce robust prices. Thus, transparency in the price discovery process is critical to building credibility and trust, and this implies the market needs breadth. For many commodities and financial instruments, this means connecting local markets to global markets. If a country opts for policies that tend to insulate its markets from global influences, then the resulting price discovery process is unlikely to be viewed as robust or useful for resource allocation. This has the resulting implication that domestic prices can be de-linked from global prices, and the country’s consumers and producers do not have their appropriate influence on world prices.
There is virtually no way that the price discovery process in China can provide appropriate incentives for commodity and financial resource allocation if the domestic markets are not linked to international markets. Normalization of the Chinese renminbi is another critical next step in linking domestic and international markets. Price discovery in China will be inherently flawed until this step is completed.
Finally, there is the challenge of creating a regulatory environment that can guide financial market reforms, ensure the integrity of markets, and yet not slow the reform process to a crawl. Accepted international rules must be put in place and the rule of law must be the final word in markets. China is well on the way in meeting these challenges, and it can avoid the mistakes made in the US, Europe, and Japan where layers of unneeded regulatory complexity have disrupted reforms and slowed economic growth.
From cross-border reforms that will link domestic to global markets, from interest rate market reforms that will impact every economic process with a time dimension, from adoption of international regulatory standards, from advances in convertibility of the RMB, to the simultaneous encouragement of innovation in futures and options markets to support liquidity in spot (or cash) markets and enhance the price discovery process, the time now seems appropriate for China to capture immense benefits for its economy.
This post is adapted from a speech delivered by Leo Melamed at the International Advisory Council in Beijing, China, November 28, 2016.
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