Launch of stock-index futures offers new tools for short selling

Amid a run-up in Chinese stock prices that has sparked warnings of a bubble, two new derivative products that offer investors tools to take bearish bets on the market debuted in Shanghai on Thursday.

Exactly five years after launching mainland China's first equity future, based on the large cap CSI 300 index, new futures products based on the CSI 500 and Shanghai Stock Exchange 50 began trading on Shanghai's China Financial Futures Exchange. The move follows February's roll-out of equity options based on the SSE 50.

China has moved cautiously to expand financial derivatives in recent years, wary of the role that such instruments played in the 2008 global financial crisis. At the same time, regulators have pledged to promote financial innovation and offer investors new hedging tools.

Small cap shares - especially tech stocks - have outperformed large caps during the recent world-beating rally in mainland shares. Low per-share prices and the limited supply of outstanding shares make small caps especially tempting to the retail speculators who dominate China's equity market.

Shenzhen's Nasdaq-style ChiNext board, which is composed largely of tech companies and small manufacturers, was trading at 91 times 12-month historical earnings at Wednesday's close, even after suffering its worst one-day fall since December on Wednesday, due in part to investor worries over the impact of new futures products.

The eye-popping valuations have led some market watchers to warn of a bubble in small cap shares. But until now, investors lacked the tools to express this view.

CSI 300 futures were considered a breakthrough in 2010 because they expanded investors' ability to conduct short selling. Today, they are among the most liquid products in China's equity market.

However, the CSI 300 is composed exclusively of large cap shares, especially banks and state-owned industrial conglomerates

The two new futures products launched on Wednesday greatly expand the short selling toolkit, especially the CSI 500 product, whose index is composed entirely of medium and small cap stocks. Now, analysts are warning that the launch of small cap-focused futures products could spark a correction in some high-flying share prices.

"The introduction of A50/500 index futures will spur a performance divergence between large and small caps," Hao Hong, research director at Bocom International in Hong Kong, wrote on Thursday.

"Mutual funds' heavy positions in small caps give strong incentives to lock in gains or even go short with the launch of the A500 index futures. It remains to be seen how a contagion from potential fallout in small caps/ChiNext will spread to large caps in the near term."

Foreign investors accredited through China's Qualified Foreign Institutional Investor (QFII) programme are permitted to trade equity futures.

The market remains closed to participants in the Hong Kong-Shanghai Connect programme, the more loosely regulated alternative channel for foreign investors to access mainland equity markets. But a Shanghai stock exchange official said in January that regulators were considering opening up the futures market to connect participants.

China launched a separate programme for short-selling of individual stocks earlier in 2010, but that was limited to large caps, and remains little-used due to the high cost of borrowing shares to sell short.

Additional reporting by Ma Nan

Twitter: @gabewildau

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