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CME Group’s new Renminbi Futures for Hedging and Investment Dr Hai Xin, Haxius Consulting

February 25, 2013

The use of the Chinese renminbi as a currency to settle international trades and to conduct various banking and investment transactions outside mainland China has been growing since the Chinese government sanctioned its offshore use in 1997. But the pace of adoption had been slow, especially compared with the rapid rise of China’s share of global import and export flows. By 2009, China had already surpassed U.S., Germany and Japan to become the world’s largest merchandise exporter and China had become one of the dominant importers of many important raw materials in the world, ranging from crude oil and iron ore to soybeans.

Renminbi’s share in the international currency trading turnover had gone up 30 times between 1998 and 2010 according the Bank for International Settlement’s foreign exchange surveys. A “great leap forward” it seems, but renminbi only accounted for a paltry 0.3% in world currency trading turnover in 2010. The Hong Kong dollar accounted for 2.4% and the Indian rupee 0.9%. The U.S. dollar still towers over the global FX market, as it factored in 85% of all foreign exchange transactions. Chart 1 shows the relative standing of a selection of world’s currencies relative to Gross Domestic Product per capita level and to import and export level.

The main reason behind the renminbi’s lackluster performance: Chinese government’s exchange rate control. Any money flows in and out of mainland China were checked and explicit permissions were needed for nearly all kinds of currency transactions if they involved Chinese renminbi and/or were done by entities in China. Apart from a few small-scale experiments in Hong Kong and a handful of other neighboring countries, renminbi and associated banking services were not available outside the mainland China. The tension had been building up in various areas, both in and outside China.

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Chart 1 China's FX turnover relative to its total foreign trade and its GDP per capital from 1998-2010

Source: Xin, H (2012). The RMB Handbook. Risk Books. Adapted from Cheung, Ma and McCauley (2010).

Chinese government gave the process of renminbi internationalization a major push in July 2010 when the People’s Bank of China (PBOC) and Hong Kong Monetary Authority signed a memorandum and at the same time the PBOC signed the “Clearing Agreement” with Bank of China, a Hong Kong-incorporated bank, to appoint the latter as the clearing agent for offshore renminbi transactions through Hong Kong.

At the same time, Chinese government announced a series of new policy measures to loosen the tight control over cross-border currency flows, starting with trade settlements and then gradually extended to some capital account items. The move effectively established a new currency: the offshore deliverable renminbi, dubbed CNH (H for Hong Kong due to the location of the appointed clearing bank). In just 2 ½ years’ time, the offshore renminbi market has grown substantially and renminbi-denominated or -linked products have mushroomed, ranging from banking products to capital market product to asset management product to insurance products.

In the FX arena, the over-the-counter CNH FX forward and swap market has gone from nothing before the announcement to around $3 billion turnover per day, close to that of the offshore non-deliverable-forward (NDF) market in renminbi. The renminbi NDF market, in existence for over 15 years, had been used primarily by offshore market participants to bet on renminbi appreciation and/or to hedge any renminbi exposures.

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For a long time, the premium (and occasional discount) of renminbi against the U.S. dollar has been interpreted as the market consensus forecast of future direction of renminbi. Sometimes when such premium was too big, onshore entities from mainland China were tempted to use its offshore affiliates to trade offshore renminbi NDF contracts to capitalise on the price differential between on- and offshore markets for renminbi. Such arbitrage transactions brought the pressure on renminbi from offshore to onshore market. Chinese government had at different times reiterated its prohibition on such profiteering acts and also voiced its displeasure to offshore banks that offered such products.

Since its policy push to internationalize its currency, Chinese government's attitude to this “unauthorized” trading of renminbi has softened markedly but renminbi NDF has been faced with the new competitor, the CNH forward. These two instruments offer slightly different exposures to renminbi: NDF is fixed against onshore official FX fixings and has been priced according to offshore demand and supply of renminbi, driven mostly by appreciation expectation; the deliverable CNH forward is priced by the interest rate arbitrage relationship and the demand and supply influence directly the spot CNH price as well as offshore renminbi interest rates.

There is a third set of renminbi forward prices available through the authorized onshore FX market, available to authorised onshore players. That market is tightly controlled by the government with daily fixing price, daily trading band, regular central bank intervention and various administrative measures designed to control the onshore market-makers and other participants.

These three sets of renminbi forward contracts have different market mechanics and different market participants and therefore from time to time their prices can differ substantially. However, large price discrepancies attract arbitrageurs who can find ways to trade in several markets and the experience over the recent 2 ½ years indicates that the prices have been moving closer to one another in general. Future liberalization measures gradually introduced by the Chinese authority will also increase the degree of fungibility between offshore and onshore renminbi and help to eliminate the price differences. One interesting point worth noticing is that over the last 10 years, the bid-offer spread on the offshore NDF has hardly gone down despite the fact that the daily trading volume has increased by over 30-fold and the bid-offer spreads in most other currency pairs have been tumbling.

CME’s New CNH Futures

Historically, OTC-traded FX forwards had dominated the corresponding exchange-traded FX futures due to a host of reasons including customization, convenience, liquidity and so on. The price discovery and dissemination function offered by exchange trading was not thought to be as important. However, there had been one major exception during those earlier years: for some emerging market currencies, the turnover of futures, when available, had often been higher than the corresponding forwards, and the bid-offer spread lower.

Over the last 10 years, however, the FX futures market has staged a major comeback with significantly higher volume growth and increasing level of market participation across different types of end-users. High-frequency trading is one reason behind the growth, but the shortcomings

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of the OTC forward market, woefully exposed during the global financial crisis, are another. The raft of new banking and financial regulations introduced in various countries such as Basel III and the Dodd-Frank Act will likely underpin further expansion of futures market at the expense of forward market. Over the recent few years, CME Group, the largest regulated FX marketplace in the world, has shown rapid growth in its FX products across all currency pairs. This is likely to be a precursor for what will happen in the coming years.

For the relatively new currency CNH, there will soon be two futures contracts available, offered by the Hong Kong Stock Exchange (HKEx) and CME Group. HKEx’s contract went online in September 2012 and CME Group’s alternative will be available in February 2013. Given the huge potential for the offshore Chinese renminbi and the long-suppressed demand for hedging products both outside and inside China, it is perhaps not surprising two sets of futures contracts on the same currency pair appear in such quick succession.

Since these two futures contracts are both on USD/CNH exchange rate and both are deliverable, the headlines features are very similar. There are nevertheless a few important differences between them, which some investors may find more or less appealing due to their specific circumstances. The following table summarises the key differences:

Categories HKEx CME Group Comments Contract size US$100k fixed Two sizes: a standard

US$100k and a mini version of US$10k

CME Group’s mini-version may be attractive to retail investors and could also be useful for hedgers and investors to fine-tune their positions.

Maturities The next three months, then next three quarters, in total 12 months.

Standard: 13 consecutive calendar months (Jan, Feb, Mar, Apr, May, Jun, Jul, Aug, Sep, Oct, Nov, Dec) plus 8 March quarterly months (3-year maturity range) E-micro: 12 consecutive calendar months (Jan, Feb, Mar, Apr, May, Jun, Jul, Aug, Sep, Oct, Nov, Dec)

CME Group’s offering has a longer range. This is important for traders looking to trade across the CNH yield curve as interest rate instruments may not be as liquidly traded. But the advantage for using the longer dated futures to hedge longer dated exposures may be superficial.

Trading hours

9am to 4:15pm Hong Kong time

5pm to 4pm next day Chicago time (Open 23 hours; closed either between 6~7am or 5~6am Hong Kong time)

CME Group’s much longer trading hours may appeal to a global audience. But the main liquid trading hours are probably going to remain the Asian hours in the near future.

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Categories HKEx CME Group Comments Position limit 8,000 lots net and

2,000 lots for the spot month.

1,000 lots of standard contract and 500 for the last week before expiration.

HKEx allows bigger position taking but both exchanges are likely to revise these limits as the market develops. HKEX’s margining arrangement will act as a limiting factor on its maximum position.

Margins At least 50% of initial margin must be in CNH. There is an additional 20% margin for spot month contracts. T+1 for margin calls.

All forms acceptable securities for initial margin. No additional margin for spot month contracts. T+2 for margin calls.

CME Group’s arrangement is more flexible and more suitable for investors based outside the Asian time zone.

Physical delivery

Yes, but based on TMA fixing.

Yes, as per standard physically delivery.

CME Group’s offer is more straightforward.

There are a few other differences in terms of market-makers and fees. The differences listed above may be important for some end-users but for many others they are probably just small technical concerns.

However, one feature could be a vital consideration for an end-user to choose between the two alternative offerings: the exchanges themselves. HKEx is the pre-eminent exchange in Hong Kong and a true hub for all local securities and related derivative instruments, mostly index futures. Being Hong Kong, these securities include the majority of overseas’ listed securities and derivatives by mainland entities. There will for sure be more CNH-denominated products coming on board on HKEx as the process of renminbi internationalisation deepens. Additionally, HKEx’s CNH future is the first and only FX future on the exchange.

In contrast, CME Group is the largest regulated FX exchange in the world by a very big margin with over $120 billion of trading per day. In renminbi alone, CME Group will offer both deliverable CNH futures as well as RMB futures based on onshore fixings, a boon for players who look at arbitrage opportunities between the aforementioned price discrepancies. And CME Group offers a wide range of derivatives in interest rates, equity indices, commodities and some alternative assets, many of which set or directly influence the prices for the underlying assets on a global scale. Also, CME Group offers clearing service to both exchange traded and OTC traded products, a vital requirement in the new regulatory environment.

For example, according to the recent announcement on the implementation of the Dodd-Frank Act, all OTC-traded FX NDFs and options will need to be centrally cleared, and CME Group has capacity to clear these contracts. We feel that the ability to trade and to clear as many products as possible via a single venue can bring significant efficiency gains for an end-user.

Using CME’s CNH Futures for Hedging

A futures contract works in a very similar way to a forward contract. In one example, USD/CNH spot is traded at around 6.20 on January 10, 2013, while June delivery futures are traded

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at 6.25. In other words, the market is currently pricing in 500-pip renminbi depreciation over the next five months or so. An investor can sell the futures to express a view that renminbi may actually appreciate over this period. Let’s assume that he sells 10 lots at 6.25 and waits until May or June to close out the contracts at the price of 6.15. His profit on this trade is therefore:

-10 x (6.1500-6.2500) x 100,000 = CNH 100,000.

Note that the units in the above equation are: -10 lots, negative sign denoting short position; (6.1500-6.2500) CNH per USD; and 100,000 USD / lot.

If, however, renminbi does not appreciate but stays at its current level in June, the investor still makes some profit due to market discount for buying renminbi:

-10 x (6.2000-6.2500) x 100,000= CNH 50,000.

Only when renminbi depreciates beyond 6.25 in June will the investor lose money. Let’s assume that renminbi depreciates to 6.35 over the next five months, the investor’s loss would then be:

-10 x (6.3500-6.2500) x 100,000 = -CNH 100,000.

The profit and loss calculated in these scenarios will not happen as a single cash-flow event at the end of the contracts. In fact, the profit and loss will accumulate daily via the margining arrangement between the investor and the clearing house. When the expiry date of the contracts approaches, the P&L will already be in the margining accounts. The investor could decide to close out the contracts or to roll them forward. Alternatively, the investor could take delivery at expiry: to receive CNH and pay USD at the effective exchange rate of 6.25 CNH per US$; namely, receiving CNH 6.25 million and paying $1 million. After taking delivery, the investor can sell CNH at the market price, the resulting profit and loss would be very similar to the above calculations. This example is illustrated in Chart 2:

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Chart 2 Illustration of short 10 lots of USD/CNH futures

The CNH futures can be used in a variety of hedging situations. Below we sketch a few simple scenarios.

Situation Hedging solution Result A German machinery exporter expecting a CNY30 million payment from a Chinese importer in November 2013 as the Chinese importer prefers to pay in renminbi.

Buy December 2013 USD/CNH futures at 6.2800.

Number of contracts to buy: 30,000,000/6.2800/100,000=47 lots. In fact, the exporter could buy 47 standard and 7 mini contracts to make the hedging more accurate but this is will not change the broad picture. Additionally, the German exporter can buy EUR/USD futures to cover his exposure to USD. Buy December 2013 EUR/USD futures at

1.3300. Number of contracts to buy: 30,000,000/6.28/1.33/125,000=28 lots. Again, additional mini contracts could be purchased if needed.

The expected value in Euro for this exporter is close to 30,000,000/6.28/1.33=EUR3.6m irrespective of exchange rates movements between renminbi and Euro. Illustrated in Chart 3.

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Situation Hedging solution Result Chart 3 Illustration of a German machinery exporter's renminbi-denominated receivable A Chinese QDII manager is managing a global equity portfolio denominated in renminbi, and his assets under management are around US$20 million. He would like to insulate his portfolio from any future renminbi appreciation. He may also want to remove other main currency risks.

Sell March 2013 USD/CNH futures at 6.2100.

Number of contracts to sell: 20,000,000/100,000=200. The choice of the maturity of the futures contracts to sell is dependent on several factors, including the subscription/redemption cycle of the QDII fund, liquidity of the futures contracts, etc. The hedging contracts will need to be rolled over when getting closer to maturity date. Also, the hedging contracts need to be monitored and adjusted in order to ensure that the notional size roughly matches that of the underlying portfolio. Sell EUR/USD, JPY/USD, GBP/USD futures if

needed The fund is still exposed to the risk of US dollar going up or down vs a range of other currencies where the fund has underlying holding. The numbers of contracts to sell in every currency pair need to be determined by looking at fund’s asset allocation and/or its benchmark.

The currency risk between USD and renminbi is removed by the first transaction. The second set of transactions further removed currency moves between other currencies and the US dollar as these can be much more volatile than the USD/CNY risk. Illustrated in Chart 4.

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Situation Hedging solution Result

Chart 4 Illustration of a Chinese QDII fund's FX exposures and potential hedging transactions

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Situation Hedging solution Result A China themed fund owned by a global asset manager invests in onshore securities via QFII and Hong Kong listed Chinese securities. The fund offers several share classes denominated in USD, EUR, JPY and KRW for local distributions. Total assets under management are around US$50 million. The manager intends to hedge renminbi risk against other base currencies selectively.

This situation is more complex and needs some detailed analysis in order to establish the optimal hedging strategy. The QFII portion invested onshore can be hedged directly using USD/CNH futures if the base currency is USD; for other base currencies, additional futures may be required to remove the fluctuation between USD and EUR, JPY and KRW The portion invested in Hong Kong market is denominated in Hong Kong dollars. However, the renminbi risk may be embedded in the price movements in these securities. The manager can choose to hedge part of this embedded renminbi risk by buying USD/CNH futures when US dollar is the base currency.

Investment in the mainland can be hedged using USD/CNH futures when US dollar is the base currency. Hong Kong listed Chinese securities require more careful consideration when choosing hedging strategies.

A Chinese importer needs to make quarterly purchases of soybeans from suppliers based in Canada. The price is set in Canadian dollar according to the most recent market price of soybeans. His quarterly purchase is around 1,000 tons.

The Chinese importer can selectively use the following three futures to manage the risks involved in his business: USD/CNH futures for exchange rate

movement between renminbi and the US dollar, particular over concerns of renminbi depreciation.

CAD/USD futures for exchange rate movement between the Canadian dollar and the US dollar.

Soybean futures to manage the price fluctuation of soybean in US dollar.

The Chinese importer can use one or more of these futures contracts to control his expenditure on his regular soybean purchase.

Using CME CNH Futures for Arbitrage and Investment

As we mentioned earlier, there are three sets of renminbi forward prices traded at different markets and following different market dynamics. Over the medium- to long-term, these prices will converge eventually as restrictions on renminbi cross-border movement are gradually removed. But before that, there should still be occasions where greed, fear or demand and supply factors could conspire to result in significant price differentials (see Chart 5), which could present arbitrage opportunities. These opportunities could be exploited via onshore and offshore OTC forwards and NDFs, or via offshore futures. CME Group offers two sets of renminbi futures (in fact, three sets but two sets are relating to the same underlying with two different ways to quote) that can be used in combination for such purpose.

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For example, if one year USD/CNH future is traded at 6.28 but the corresponding USD/RMB future is traded at 6.32, an investor can buy USD/CNH at 6.28 and sell USD/RMB at 6.32 and wait for the spread to narrow as the maturity comes nearer. When the spread between two futures is smaller than 0.04 RMB per USD, the investor can then unwind the initial trades to capture the profit. However, this strategy is not risk-free. It is possible that the spread persists until the maturity and the investor in effect sells offshore renminbi at 6.28 to one U.S. dollar and buys onshore renminbi at 6.32. While the onshore leg is closed at PBOC onshore fixing, the offshore leg can only be closed at offshore CNH spot, which could trade higher or lower than the onshore fixing.

The arbitrage set-up will be much richer for players who can access both onshore and offshore FX markets. Over time, these arbitrage trades will help to bridge the gap between onshore and offshore markets and facilitate the process of renminbi internationalisation.

Over the recent 10 years, most investment themes relating to renminbi have been on the appreciation of renminbi itself and the rapid accumulation of renminbi deposits in Hong Kong and a few other locations since the birth of CNH are a reflection of that motivation. To play on the renminbi appreciation theme via futures is relatively straightforward: you sell USD/RMB futures. The only decisions to make are how much and what maturity.

Now the general consensus shared by many market participants, including the Chinese government and the International Monetary Fund, is that the USD/RMB exchange rate has reached a level reflecting economic fundamentals. The investment focus will instead be renminbi-denominated offshore financial products, including ‘dim sum’ bonds, as well as direct investment opportunities. These are being introduced to the global market in quick succession. The next major step in the development of CNH market would be to lend offshore renminbi to onshore entities in order for the factional reserve banking principles to take full effect and “create” more offshore renminbi.

The Qianhai experiment in Shenzhen, where foreign banks are permitted to lend offshore renminbi to onshore corporations under a quota system, is the first baby step, and there will probably be many more to come. In this new environment, the trading of USD/CNH futures can be used in a variety of ways, from directional plays to fine-tuning the timing of offshore renminbi cash flows in order to facilitate other investment activities in offshore renminbi, from opportunistic arbitrage transactions to selective hedging of renminbi currency risk.

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Chart 5 One-year renminbi forward prices, onshore vs offshore NDF and CNH, 2003 to 2012

Source: Xin, H (2012). The RMB Handbook. Risk Books.

Practical Considerations

The trading of CME Group’s new CNH futures will mostly follow the existing framework for all other FX futures traded on CME Group. However, an investor will need to set up accounts to pay and receive offshore renminbi. For existing users of CME Group’s FX futures and/or other futures, adding the new futures contracts would most likely be a non-event.

For someone new to futures trading all together, then there would be some practical issues to consider, including how to find a futures broker who will help the client to take the necessary measures in terms of opening accounts and so on. If a client has dealt in OTC FX market before, then many of the criteria for choosing a counterparty bank would apply here. Many large international banks have separate futures broking subsidiaries for clients. On CME Group’s website, there is a special section listing all the futures’ brokers by geographic region.

Entities based in China will need to seek special permission from relevant onshore authorities before trading.

Most futures transactions are done electronically, whereby the exchange provides the platform and various brokers provide the front end tools. Investors need to consider the connectivity

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between these front end tools and their own IT systems in order to minimize the operational risks. CME Group, being one of the earliest promoters of the electronic trading platforms, provides a suite of solutions to brokers and their clients with different levels of sophistication.

Conclusion

The two sets of CNH futures offered by CME Group and HKEx provide useful tools for institutional investors, corporations and retail investors to invest, to arbitrage and to hedge. They are viable alternatives to FX forwards and swaps traded on the interbank OTC market.

CME Group’s USD/CNH futures, together with its USD/RMB futures and many other types of futures and options contracts and CME Group's ability to clear both exchange trades and OTC contracts, will offer greater flexibility for end-users in a variety of situations.

For more information on CME Group’s CNH contract, you can visit www.cmegroup.com/rmb.

Contact

Dr Hai Xin Director Haxius Consulting Limited Hong Kong hai@haxius.com +(852) 688 99546 / +(86) 131499 99546 www.haxius.com

Haxius Consulting Limited is a Hong Kong registered company offering consultancy and educational services in financial risk management, currency overlay, derivatives, and offshore renminbi.