PROVISIONAL LEGISLATIVE COUNCIL PANEL ON FINANCIAL AFFAIRS
MEETING ON 6 OCTOBER, 1997
Red Chip Index Futures Trading Prospects and Safeguards for Investors
The Hang Seng China Affiliated Index, the so-called Red Chip Index, was launched in June 1997 by HSI Services Limited. Futures and options contracts on the Index commenced trading on the Hong Kong Futures Exchange Limited ("HKFE") on 12 September, 1997. The introduction of the Red Chip futures and options contracts provide a facility for investors to hedge against their risks accruing from the cash market and help add depth to the Hong Kong market.
The characteristics and specifications of the Red Chip Index futures and options are similar to the Hang Seng Index ("HSI") futures and options trading on the HKFE, save the trading in these new contracts is conducted through HKFE's Automated Trading System, the same system on which the Rolling Forex and Stock Futures contracts are trading.
The Red Chip futures market is an order-driven market while a market maker system has been established for the Red Chip options market to provide for liquidity.
The introduction of Red Chip Index futures and options contracts is not the first derivatives product to be introduced in relation to Red Chip shares. There is active trading on individual stock and basket warrants on Red Chip shares at the Stock Exchange. Stock futures on selective Red Chip stocks are trading on HKFE.
2.The "Red Chip Index"
The Hang Seng China Affiliated Index is calculated by HSI Services Limited, the index provider for the Hang Seng Index ("HSI") and Hang Seng China Enterprises Index ("H-shares Index"), among others.
The Red Chip Index is a market capitalisation weighted index with a base value of 1,000 back dated to 4 January 1993. The Index tracks the share prices of 32 China-affiliated corporations listed on the Stock Exchange. To qualify as a constituent stock, the company must have at least 35% of their shareholding held, directly or indirectly, by PRC entities and meet certain listing and turnover requirements established by HSI Services (see Annex 1 for the selection criteria and the list of constituent stocks).
The total market capitalisation of the index constituent stocks was $374 billion by the end of August 1997 which represents 8.62% of the total Hong Kong market capitalisation of $4,335 billion (having increased from 3.05% in August 1996). During the past one year, monthly turnover as a percentage to the total market turnover increased from 9% to 18% (see Annexes 2 and 3).
3.Volatility of the Red Chip Index
A 60-day volatility analysis indicates that both the Red Chips and H-shares' volatility (both approximately 70% by the end of August 1997) stand much higher than the HSI (approximately 35%). Although the volatility is high, it does not mean that the index is unsuitable for trading. It does mean that a prudent risk management process is important; and the Commission and HKFE have implemented world best practice in this regard.
Observing the Red Chip market in the past two weeks, the volatility does not appear to have increased subsequent to the introduction of Red Chip futures and options contracts.
4.Risk Management Measures adopted by HKFE Clearing Corporation ("HKCC")
HKCC has adopted the same margining methodology as it uses for the HSI futures and options to calculate the margin requirements for Red Chip products, save a more conservative stance in margin levels has been taken.
The initial client margin for Red Chip futures is 580 index points (i.e. $29,000), equivalent to approximately 18% of the contract value (based on the current index level of 3,200 times the contract multiplier of 50 equals $160,000) as compared to approximately 6% for the HSI futures. In other words, three times or more margin in terms of the contract value. Statistics show that a margin rate of 430 index points can cover 100% of the movements (on daily closing price changes) of the Red Chip Index for the period from 4 January 1993 to 4 September, 1997.
Margins on Red Chip client options positions are calculated using SPAN methodologies which are used to calculate the margin requirements for clients on HSI options.
‧Intra-day Margin Calls
In addition, HKCC will call intra-day margins from brokers when the Red Chip Index futures contracts have experienced a movement by 150 index points from HKCC's last calculation of margin requirements to protect the clearing house in any adverse market situations. HKCC had called three intra-day margins, which were met within an hour, since the launch of the products.
HKFE imposes capital requirements on its members which parellel and augment the Commission's Financial Resources Rules.
‧Capital-based Position Limits
HKFE Rules impose limits on the maximum number of open positions which are allowed to be held by each member based on the members' capital. An HKFE member cannot trade above this limit unless it adds additional capital to its business.
‧HKFE Inspection Visits
HKFE staff regularly make inspection visits of members' offices and check for compliance with the Financial Resources Rules, customer protection laws such as segregation of clients' fund, and the Code of Conduct.
‧Code of Conduct
HKFE has a Code of Conduct that applies to all members' dealing and their relationships with clients. It requires, among other things, that members assure themselves that clients understood the nature and risks of futures dealing and can bear the potential losses.
5.Market Controls by HKFE
The Red Chip market and participants are subject to a number of existing and additional compliance and market surveillance controls by HKFE to ensure the orderly and safe trading of the market. These controls include:
Unlike the HSI futures and options markets (where there is no position limit), a position limit of 10,000 contracts per member and per client is imposed on the Red Chip futures and options contracts. This limits brokers and clients' ability to build up a large position and thereby reduces the risk of default and market manipulation. Please note that the Commission has also made rules to impose identical statutory position limits, violation of which is a criminal offence.
‧Large open position reporting
Brokers are required to report to HKFE any large client or house open positions of 500 or more contracts. This information indicates the concentration of risks as such to assist HKFE in monitoring the market. Again, the Commission has made rules to impose identical statutory reporting requirements.
‧Analysis of trading reports
HKFE staff review a number of daily reports and analyses to identify indications of breaches of HKFE Rules. These include cross trades reports, detailed volume analyses, position allocation analyses and price activity reports.
6.Calculation of the Final Settlement Price
Similar to the HSI products, the final settlement price for Red Chip Index futures and options is based on the average of the Red Chip Index taken at five minute intervals on the last trading days of the contracts.
The launch of the Red Chip futures and options are considered successful. 10,843 futures and 138 options contracts have been recorded from 12 September to 23 September, 1997 with an average daily turnover of 1,549 futures and 20 options contracts. Open interest on 22 September was 4,613 futures and 74 options contracts.
‧HKFE's Surveillance Functions
As mentioned, HKFE has implemented measures to reduce potential default and market manipulation to protect the interests of the investing public.
HKFE conducts, from time to time, training courses for brokers and the public to enhance the knowledge of both market practitioners and users on the characteristics and risks of new products.
HKFE discloses to the public the potential risks associated with the Red Chip products. A risk disclosure statement in reasonable size and bold letters was published under the advertisements for the products prior to the launch (see Annex 4).
Booklets on Red Chip Index futures and options with proper risk disclosure are published for distribution to brokers and their clients. Pursuant to HKFE Rules, brokers are obliged to explain the nature and risks of the products to their clients prior to any order execution.
‧Clearing House and Reserve Fund
The Reserve Fund which stood at over $700 million by the end of August 1997, provides a backup facility to assist HKCC in meeting its obligations as counterparty in circumstances where an HKCC member defaults. HKCC also closely monitors and evaluates the risk exposure of the market on daily basis to ensure that the size of the Fund is sufficient to cover certain default assumptions made by HKCC.
The Compensation Fund established by the Commodities Trading Ordinance is in place to compensate investors who suffer losses in the case of default by an HKFE member. The current amount of compensation availabe is $2 million per broker per default.
In view of the continuing growth of the Red Chip market, we could envisage an increase in the demand for Red Chip derivatives. This demand will extend not only to the Red Chip futures and options markets, but also to the individual Red Chip stock and basket warrants traded on the Stock Exchange, and other over-the-counter derivatives.
We believe that if HKFE can continue to carry out its prudent regulatory measures, the Red Chip futures and options market will grow in a steady pace and should add liquidity and depth to the overall Hong Kong market.
Securities and Futures Commission
30 September 1997