Margin Trading in China: Blessing or Curse?

Written by Victor Fan || December 03 2012

Margin trading is an important part of financial markets, especially for derivatives although the use of margin trading is still somewhat controversial in certain markets. In China, margin trading is relatively new and the phenomenon and behaviors observed in the markets from the use of margin trading are quite different from those of western markets. In order to better understand the markets, its worth taking some time to analyze the differences and provide suggestions to utilize the opportunities from the development of Chinese margin trading market development.

 Margin trading is leverage. You only need to pay for a portion of the whole amount to buy certain financial products and the rest of the capital can be borrowed from securities companies or brokers. Higher risks, higher returns is the essence of margin trading; most cases of rogue traders have some combination of margin trading with aggressive trading strategies and the failure of risk control management. In China, the structure of investors in the derivatives market is distinct from the west: individual investors account for a large proportion of the volume in the Chinese derivatives market and institutional investors have less influence. In the future, the number of institutional investors participating in the derivatives market will increase, although perhaps not to the extent that they have in western markets.

Another clear difference between Chinese derivatives market and western markets is the different usages of derivatives. Typically there are 3 main reasons to invest in the derivatives market: to hedge, speculate and/or arbitrage. In the west, hedging and arbitraging are quite common as most western investors are institutional and therefore have stronger motives and capabilities for hedging and arbitraging. Institutions also tend to be relatively more “rational investors” as compared to individual investors as institutions are more professionally educated and trained. In China, more individual investors and even fund traders are more likely to be speculative. Chinese investors tend to make quick money from high frequency trading in the derivatives market, and technical analysis prevails rather than fundamental analysis, which leads to irrational fluctuations in derivative pricing.

The lack of regulatory supervision and individual investor protection are additional indications of China’s immature margin trading market. As an example, in the futures market, there is no limitation for one person or fund to open up multiple accounts. The brokers and securities companies in China always provide very low trading fees for the institutional investors, and this made it possible for the institutional investors to open up multiple accounts to trade the derivatives within these accounts to create illusions of large trading volume in order to allure more individual funds. As the individual investors are relatively less experienced and vulnerable against the risks, the institutional traders can make money from them by pushing price up or down dramatically to force individuals into difficult situations. Often individuals then, because of the daily settlement requirement, will end up paying for additional margin if they have less money than the minimum margin in their account. If the individuals are not capable to pay for that before the next transaction day, they will be kicked out from the margin trading market from the next day which means they have no rights to keep holding the derivatives, even if the index is performing very well on the next day.

In order to catch up with the maturity of western derivatives markets, the Chinese government, regulators, and derivatives exchanges encouraged institutional investors to invest in the derivatives market and also considered the introduction of QFII’s to the derivatives market. Opportunities will emerge for financial IT firms because the increasing institutional investors require sophisticated trading software especially the high frequency trading software. In addition, as the Chinese investors are gradually becoming rational, the demands for arbitrage and hedging will surpass the demand for speculation, which is also a good opportunity for developing financial engineering and program trading. Moreover, new forms of derivatives will likely be introduced to the Chinese market such as options, which is also a good chance for financial IT firms to get ready to take the early mover advantage. In general, although the margin trading is highly risky, for financial IT firms, it may not be that risky at all.