Cash Management and Innovation in Futures Settlement in China
Margins are required in domestic futures trading and clearing, of which there are two types: clearing margins and trading margins. The clearing margin is the capital deposited by the members in the special clearing account before the transaction. According to the current stipulations of China’s three futures exchanges (the Dalian Commodity Exchange, the Shanghai Futures Exchange and the Zhengzhou Commodity Exchange) each floor balance is RMB2m for a brokerage member and RMB0.5m for a proprietary member. In other words, if a futures brokerage company is a member of all three futures exchanges, it has to pay at least RMB6m in capital as its clearing margin.
Under the regulations of the China Securities Regulatory Commission and with approval from the futures exchange, members can also use standard warrants registered in the exchange and other approved collateral as their trading margin, although expenses such as trading losses, fees and taxes must be settled in cash. However, only standard warrants can be accepted in practice. Based on the above-mentioned regulations, there are only two kinds of margins in domestic futures settlement, i.e. cash and standard warrants. There is a haircut of about 20 per cent incurred by standard warrants, while cash earns interest at the rate given by the People’s Bank of China for current accounts. On the interest payment day of every quarter, the clearing banks will either transfer the accrued interest into the member’s special capital account for payment or capitalise it into the member’s clearing margin. Because of the high costs associated with standard warrants and the limited interest earned for cash reserve funds, members require an efficient way to manage their capital.
To meet the ever-stricter demands imposed on members and investors for the efficient use of capital and the prompt transfer of their futures settlement funds, the Shanghai Futures Exchange has made a number of developments in futures trading cash management. In co-operation with the Bank of Communications, it has developed an electronic system called BECK, which was launched recently. The first comprehensive cash management system for banks in the Chinese market, the system integrates the data from clearing banks on the same cash management platform and allows functions, such as automatic transfers, real-time enquiries and online monitoring.
With regard to the forms of margins, it is worth learning from the experience of other international futures exchanges. From international experience, in order to increase flexibility and decrease the financial burden of investors and brokerage companies alike, margins can take the form of bonds issued by governments and government institutions, stocks, foreign currencies and sovereign bonds, asset-backed bonds, or letters of credit, etc. However, using securities as collateral may increase the credit risk, the price risk and the liquidity risk. It is also costly to manage and evaluate the securities and to determine a rational discount rate. Thus, securities are rarely accepted as either reserve funds for settlement or for margins in futures trading. The question is: is there a way to reduce investors’ cost and provide both a low risk and high liquid solution to meet capital needs in futures settlement?
The Chicago Mercantile Exchange (CME), the largest futures exchange in the US, has put forward an idea to take advantage of money market funds, substituting them for cash and different kinds of collateral in futures settlement. By investing in a variety of highly liquid money market instruments, money market funds provide investors with comparatively high yields and ensure capital safety through a diversification of risks. By choosing different collateral management programmes offered by the CME, settlement members can enjoy the following advantages:
The basic characteristics of the CME’s five IEF programmes are as follows:
Launched in February 1997, the IEF1 is a money market fund in which the CME guarantees the principal and the accrued interest. The CME does not apply a haircut on this product, and there is no supervisory capital haircut either. The fund can only be invested in US government securities. An automatic cash deduction and transfer facility for margins is provided.
Launched in July 2001, the IEF2 is a money market mutual fund that can be directly invested in any of the CME’s 28 approved institutional classes of money market mutual funds. The CME levies a 1 per cent haircut on all IEF2 holdings and a 2 per cent regulatory haircut. A diversification policy is required for investments over US$100m.
IEF3 and IEF4 are specialised securities programmes that enable settlement members to pledge securities allowed under Regulation 1.25 of the Commodities Futures Trading Commission (CFTC) but not directly accepted by the CME. The programmes are supported by the Bank of New York and JPMorgan Chase. Under IEF3 (the overnight pledge of securities programme) settlement members debit their cash in the morning and substitute the cash into collateral allowed by Regulation 1.25 of the CFTC with the permission of the CME. The collateral is transferred to third-party accounts opened with Bank of New York or JPMorgan Chase controlled by the CME. The term of the collateral terminates the next morning and a new round of operation begins, which is similar to the practice of overnight investments. Under IEF4 (the term pledge of securities programme) the terms of the pledge can be defined by the settlement members, and the collateral, within a certain amount, can be substituted on a business day.
Launched in July 2004, the IEF5 is a specialised cash programme supported by JPMorgan Chase. IEF5 is a bank account that pays a monthly-accrued interest to the settlement member’s cash deposited in the bank’s trust account. The interest rate is linked to the effective rates of federal funds.
The practice of using money market funds in futures settlement can be of value to futures exchanges in China: for futures broking firms and investors, they can reduce costs; for futures exchanges, they help to increase liquidity by reducing investment costs; and for settlement banks and other financial institutions, they increase business opportunities.