Overseas financial service providers are eager to tap the Chinese financial derivatives market as the country's regulators gradually loosen the grip.

A few weeks ago, Credit Suisse First Boston (CSFB) was granted a license from the China Banking Regulatory Commission (CBRC) to conduct financial derivatives trading on the Chinese mainland.

"I believe a robust derivatives market is necessary for China to become a world financial leader," said Paul Calello, CSFB's chairman for the Asia-Pacific region.

Euromoney and CSFB organized a special "China Derivatives" summit last month, which attracted many participants eager to explore this virgin territory.

China will have the world's second-largest securities market next to the United States by 2010.

The greatest growth in recent financial services in developed economies has been in derivatives.

With China's equity market racing ahead, it is logical that a mushrooming will take place of derivations such as interest-rate- or credit-linked instruments if stable and smooth development continues.

The CBRC issued the Interim Rules on the Administration of Derivatives Business of Financial Institutions earlier this year, a vital step to opening up the derivatives market.

These rules provide comprehensive measures for entry requirements, licensing procedures and risk management.

The regulator's decision to allow qualified financial institutions to trade in derivatives is a major milestone for China, some industry executives said.

It will benefit corporate China significantly and improve a variety of financial derivatives including rate-, credit- and forex-linked products.

As to market admission, the participants must meet the requirements stipulated by the rules: a sound risk system and internal controls; front, middle and back office transaction process systems; real-time risk management; senior management with five-year derivatives experience, two dealers with at least two-years experience; at least one employee for risk management and at least one other for modelling risks.

However, "one of the most significant breakthroughs is the abandonment of the 'hedging propose only' requirement, said Paulus Mok, head of sales and structuring at Citibank in Shanghai. "This implied that more exotic and complex-structured products can now be offered to clients."

In January 1994, China eliminated the dual exchange rates system and implemented a managed floating rate system. With the steady growth of the foreign trade with the outside world, import and export trade-oriented companies have to cope with exchange rate fluctuation to avoid losses.

Starting from 1999, yuan forward is available on the Chinese mainland formally. Meanwhile, alternative hedging means are also available in the offshore market, in the form of non-delivery forwards (NDFs).

Some experts argue that interest-rate-linked derivatives are urgently required because the rate uncertainty is part of the financial challenges the corporations have to handle with as the retractions on the rate may be eased. It is an essential task for companies to manage the interest rate exposure.

Prior to rolling out interest rates, a benchmark rate is urgently needed, some experts suggest.

They said domestic interest rates are highly managed rates and commercial lending and deposit rates are based on official orders instead of being driven by market forces.

Second, even if the Chibor (China Inter Bank Offered Rate) is quoted on the screen freely, the trading volume is limited. Also, Chibor may be distorted by some other factors.

Available products are mostly interest-rate- and forex-related derivatives, but some foreign players have positively tapped the potentially lucrative products, such as credit derivatives.

However, as the credit culture is still in its infancy and default events are still poorly managed and do not occur very often in China, there is a long way to go for the domestic market to accept the concept of credit-related derivatives.

In addition, domestic investors' mentality is still preoccupied by the outdated credit idea. The credit situation does not reflect market prices.

With the accelerated trading in non-performing loans (NPLs) by foreign banks, credit derivatives may witness steady expansion in the foreseeable future.

Future trading in the use of the equity derivatives is expected to be rosy due to the increasing expansion of China's stock market and need of the yield-enhancement and hedging products from the investors.

It is also expected to boost the sound development of the over-the-count (OTC) derivatives market as well as to life the whole performance of domestic players. The OTC market would be set to surge due to the growing needs of the customized products by corporate clients.

In fact, some foreign banks have actively launched derivatives and hope to be the first to grab a market share.

Recently, ABN AMRO, which was given the green light to conduct derivatives trading, announced the opening up of interest rate swap trading for a range of new participants with the launch of MiniSwapsTM, an innovative product enabling corporations, fund managers and institutions to easily trade and hedge interest rate risks.

MiniSwaps are open-ended securities that can be traded by users previously prevented from trading derivative contracts for regulatory, credit or documentation reasons. Available in "MiniLong" and "MiniShort" formats, users are able to trade both long and short views on interest rates and spreads.

Robert Douch, global head of distribution in ABN AMRO's financial markets business, said: "MiniSwaps are revolutionary products that open up the interest rate trading market for a range of new users. In particular, those previously unable to access this market due to required credit lines, complex legal documentation or regulatory issues now can also use derivatives.

MiniSwaps have not been registered for sale to the public in any jurisdiction and are available for sale on a private placement basis only.

The authors are industry observers and contributors to China Business Weekly.

(Business Weekly 10/13/2004 page5)