CITI: If China wants to become a major commodities trading centre, here's what it has to do

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China may be a behemoth when it comes to its share of global commodity demand, but if it wants to be become a major hub for commodities trading in the future, it has a long way to go yet, says researchers at Citibank.

In a note released this week, the bank looked at the significant increase in domestic commodity trading activity in China over the past two years, noting that open interest and daily turnover — both in dollar and contract terms — had surged with total margin deposits placed at China’s three main commodity exchanges, in Dalian, Shanghai and Zhengzhou, more than doubling from around $6.5 billion in mid-2015 to as high as $16 billion earlier this month.

This chart from Citi shows the enormous growth in margin deposits at these exchanges over the past few years.

Source: Citi

Margin deposits have grown rapidly from the middle of 2015, coinciding with the decision from the People’s Bank of China to change the daily fixing mechanism of the Chinese yuan, something it said was implemented to allow markets greater influence on determining the value of the currency.

In response to the move announced on August 11, the yuan fell by close to 2% against the US dollar.

While that initially rattled financial markets, and kicked-off a prolonged period of weakness in the yuan, it also led to an influx of domestic capital into Chinese commodity futures, including from inexperienced investors.

As trading activity in these markets soared so did volatility.

Once sleepy markets such as iron ore and coal — previously set on annual or quarterly contracts only a few years earlier — were transformed overnight, with large daily swings becoming increasingly prevalent.

Such moves, as those who watch these markets closely can attest, have only been magnified in recent years, resulting in some unbelievably remarkable moves in both directions from the beginning of last year.

It’s now unusual if there isn’t volatility, given heightened levels of speculation, than if there is.

And as that volatility has grown, so too has its influence on physical prices.

“China and its growing herd of commodity traders and financial exchanges are clearly having greater influence on world commodity pricing, particularly for certain bulks and base metals such as iron ore,” says Citi.

However, while China appears to be the heir-apparent to be the next global centre for commodities trading given the establishment of commodities exchanges and its standing as the world’s largest commodity consumer, Citi says that a few things need to happen before that transition can take place.

“Issues related to China’s market structure and liquidity hamper price discovery, keeping its benchmarks more ‘local’ than ‘global’,” the bank says.

“With much of the recent growth in open interest due to speculative activity, Chinese futures markets need more hedge flows via corporates and offshore physical players, in our view, to better balance speculative traders with end-users and producers.

“Developing robust ‘back-end’ forward curves seems critical for Chinese exchanges to play a more dominant role in global commodities trading, likely needing to be combined with less restrictive capital controls and more foreign financing and entities entering the market,” it says.

Financial reforms enabling foreign participation in these markets, essentially, helping to boost liquidity to levels seen in other global commodities centres located in London, Chicago and New York.

And while that’s unlikely to occur in the near-term, it appears that Chinese regulators are already moving in that direction.

According to Reuters, the China Securities Regulatory Commission, the nation’s financial regulator, published draft rules late last year to allow foreign investors to trade in some of the country’s commodities futures, starting with the introduction of a crude oil contract on the Shanghai Futures Exchange that’s expected to begin trading during the current calendar year.

A successful launch of that contract, should it eventuate, could lay the foundation for increased market participation, and with it the potential for greater price discovery.

Until that happens, however, it’s likely that the volatility in Chinese futures will be here to stay.

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