Spring 2013

INSIDE VIEW: Trading the odds

Odd shoesAs more exchange-traded funds are being launched within China’s renminbi qualified foreign institutional investor scheme, Andrew Clark of Lipper explores the potential for arbitrage. Launching an exchange-traded fund (ETF) typically means the issuer has at least two primary objectives to work on afterwards: growing the market share, and ensuring the on-exchange liquidity builds up. The renminbi qualified foreign institutional investor (RQFII) and qualified foreign institutional investor (QFII) total is estimated to be about 1% of the overall Chinese A-share market. Even if it reaches 3% with the recently announced increases, it will not be large enough to make an impact. With regards to liquidity, it must be noted that the RQFII launches are targeting investments in an as-yet-untapped offshore renminbi retail market. Existing A-share ETFs target the dollar-based institutional client base. While institutions could convert their dollars into renminbi, the typical existing issuer’s experience is that larger institutions prioritise the liquidity provided by the FTSE China A50. Therefore, on-exchange liquidity will take time to build up. To discuss the RQFII launches in more detail, it is useful to relate some history. China launched the RQFII scheme in December 2011 as part of its effort to further open the country’s capital account and to promote the renminbi’s international status. QUESTIONS AND ANSWERS
Hong Kong is the world’s largest offshore renminbi centre, and only Hong Kong units of Chinese fund management and securities companies are allowed to invest in mainland China via the RQFII programme. Recently, China’s Securities Regulatory Commission (CSRC) announced a three-fold increase in the quotas for the RQFII scheme. Given the launch of the RQFII scheme and the existence of the QFII presence in the China stock index futures market, now is a good time to ask two broad market questions about RQFII ETFs. Is the RQFII programme improving liquidity? Are the RQFII and QFII programmes improving the risk-bearing capacity of the domestic market? Each question addresses an important capital markets topic for which domestic regulators would likely hope the answer is yes. A positive answer to either or both questions means a broad market aspect of the ETF – versus the narrower issuer concerns – has been achieved. With the introduction of the China AMC CSI 300 index ETF, the liquidity of the underlying stocks has been impacted in a positive manner. Index stock spreads declined relative to those of non-index stocks after the introduction of RQFII ETFs. This is good news for the domestic market and a sign that the domestic regulators’ efforts to further develop the local stock market are succeeding. Also, though more tentatively, the index-stock spread reduction appears to be driven by a decrease in the temporary price impact of trades. In other words, the spread reduction is because of a decrease in the order processing and order imbalance costs of the spreads. If this is the case, we can say that the increased arbitrage trading between individual stock markets and index securities markets is adding risk-bearing capacity to the market and providing buying and selling support to order imbalances. Is there further evidence of our hypothesis that a good level of risk-bearing capacity is being added to mainland China’s stock market? Index Arbitrage in China, a research paper by Ronald Slivka, Yikai Zhang and Wenwen Zhang, found that index arbitrage is becoming increasingly prevalent in the country. It also found that the growth of index arbitrage coincides with the stated objective of the domestic regulators and exchanges to expand the use of RQFII ETF and CSI 300 index futures by foreign and domestic institutional investors. Does the CSRC need to be mindful of the CSI 300 ETF/CSI 300 index futures arbitrage? Or, in other words, is index arbitrage keeping CSI 300 index futures prices near their economic fair value? FAIR VALUE
Yes. Why? Because the “correct” economic fair value provides investors and hedgers the assurance they need to comfortably increase their participation in China’s rapidly developing ETF, stock, and index futures markets. And this fair value assessment will increase in importance as further launches of RQFII ETFs will cover more indices. Where are we now with determining the economic fair value of the CSI 300 index? As noted by Slivka, Zhang and Zhang, for the CSI 300 index futures the current zero arbitrage band – using a synthetic CSI 300 ETF – is up to twice as large as that experienced in more mature global futures markets. As more RQFII ETFs will be launched, domestic regulators need to be sure that risk-bearing capacity is being added to the domestic stock market, with the goal that the zero arbitrage band begins to approach the size of those of developed markets. Andrew Clark is manager of alternative investment research at Lipper ©2013 funds global asia

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