China index options could soon be offered to offshore investors, giving them access to another source of volatility or more adequate hedges to their long equity portfolios. While the prospects are looking good, any opening of the market will be beset with challenges, from regulatory restrictions to the sheer nature of China’s retail-dominated market. Daniel O’Leary discusses the latest potential opening of China’s capital markets. China, for equity derivatives traders, has long been an elusive market. Always threatening to open its markets in its bid to modernize and welcome the world’s investment, but never delivering. In 2014 the country seemed poised to embrace equity derivatives. The Shanghai Free Trade Zone was being established, the Hong Kong Exchange was building its so-called ‘Through Train’ with the Shanghai Stock Exchange and eyeing similar infrastructure with Shenzhen, options had started trading on the SSE 50 exchange-traded fund, futures were well established on the CSI 300 equity index and quotas on the qualified foreign institutional investor and Renminbi QFII programs were increasing. Things seemed pretty rosy. Funds established in Hong Kong were talking about opening offices onshore, sellside banks were busy building inroads, exchanges were sounding out opinion on widening options to single stocks and testing volatility products; the future looked bright. The Chinese equity crash of August 2015, sparked by a sudden devaluation of the renminbi, changed that, with plans for further derivatives products shelved. That was the case until late last year. Mainland China’s first mainland stock index options debuted on the China Financial Futures Exchange late December. They are tied to the Shanghai and Shenzhen stock exchange-based CSI 300 index. Both the Shanghai and Shenzhen exchanges also launched options on the CSI 300 exchange-traded fund in late December. The listings have given hope offshore investors could be given access to the options via their QFII and RQFII allocations. “There’s regulatory changes going through at the moment for QFII, which are going to allow access for onshore SPL, repo and margin financing,” noted a Hong Kong-based fund manager. “As those progress, it will become clear as to whether options are going to be included in that framework. I think the easiest way to do that is to allow QFII to trade these options. I’ll imagine that’ll be sometime during this year, but I don’t know when.” The Hong Kong fund manager said the inclusion and further integration of the A-Shares into MSCI indices is likely driving the development of index options and the offering of futures offshore. “One of the things [MSCI] pointed to was access to hedging instruments,” he said. “And so, the regulator is probably aware that they need to allow access to some kind of hedging futures onshore.” He added gaining access to onshore options and futures will cheapen the cost of hedging Chinese equity. Depending on rules and regulations, there may be some scope for alpha strategies, he added. “With pricing across the options curve, guys that have experience in options market making, or arbitrage; that can potentially be an opportunity, because [Mainland China] is still an unsophisticated market, I’m sure, in terms of participants with derivatives knowledge.” The 2015 crash spooked Chinese authorities as the China A-Shares market lost about a third of its value, leading to increased global volatility that saw the Cboe VIX trade above 40. With this latest round of volatility due to the global pandemic, it is too early to ascertain how Chinese authorities will react. Stephen Howard, chief investment officer at Howard Trading in Hong Kong, said there were many pros and cons to China offering index options offshore. One of those cons could be the country’s predilection for interfering with its equity markets during periods of heightened volatility. “I think they’re going to be priced at a discount because of this,” he said. “The level of that discount is going to increase or decrease on the geopolitics and the broader economy. If things are going really well, I guess it’s going to narrow quite a lot. If things are really stressed and there’s been a move in the currency and the spot markets down and the messaging is basically you can’t sell, yeah, then I guess they’re going to be significantly discounted.” China’s so-called national team is a group of five state-backed funds created after the 2015 crash that are suspected of intervening in the market, buying up equity when prompted by state regulators, in a bid to curb volatility. They are proof positive that Chinese authorities prefer market stability above all else, according to market participants. Howard, however, said the potential pros are plentiful. “It opens up a whole new source of volatility supply that hasn’t existed,” he explained. The current family of China derivatives, such as those offered on the A50 or other ETFs are quite narrow in scope, he added. Offering derivatives on the CSI 300 would give investors a broader perspective. He noted the other pro would be the retail focus of the Chinese market, which would make the behavior of the derivatives interesting for seasoned options traders.