According to figures from FOintelligence, in 2010, 1.4bn commodity contracts were traded in on exchanges in East Asia. However, in the year to the end of July, that figure fell to just 334.8m contracts, a near certain indication that volumes will fall well short of matching 2010’s levels of activity and that 2011 will mark the first ever annual fall in volumes in East Asia’s roaring derivatives markets.

Delve into the volumes and you see why Asia’s commodity markets are set to fall in 2011. Like in 2010, Asia’s big two commodity markets, India and China dominated trading, supplemented by several markets, particularly the emerging markets of Thailand, and Taiwan, and older, more established, markets like Singapore

So what’s driving this decline? Well when the biggest market suffers, the region suffers. China’s market has slowed, trading 431.87m commodity derivatives in 2011 to date but on track to fall well short of the 1.2bn contracts, which were traded in 2010. Few would have predicted such a slowdown even a year ago.

A Chinese lead balloon

Chin’s thirst for commodities has been legendary, seemingly unquenchable. China’s three commodity exchanges, Shanghai Futures Exchange, the Dalian Commodity Exchange, and the Zhengzhou Commodity Exchanges have each enjoyed strong years but when compared to the heights reached in 2010, volumes are off track and the three exchanges look set to record declines in 2011 from 2010.

According to FOi data, DCE had a strong 2010, recording 322.2m trades, down from the 353.9m trades in 2009. However, in the first seven months of 2011, the exchange has transacted just 103.4m trades. The SFE, China’s largest exchange, had a magnificent 2010 – boasting 611.2m trades, up from the 389.1m trades the year before, but in 2011, the exchange has mustered just 126.7m.

The ZCE, too had a strong 2010, home to 349.4m trades, up from the 165.8m in 2009, but in 2011 to the end of July volumes on the commodity bourse have fallen to 82.8m trades. Highlighting the drivers of such declines is usually obvious, but in this instance, it’s a combination of several factors.

Like many things in China, regulation on China’s commodity markets is tight. Participation is limited to just domestic participation, making its enormous volumes perhaps even more impressive. China’s exchanges have never been obsessed by growth, or for that matter incentivised by regulations – the Asian dragon was burnt in the early 1990s.

Against this backdrop is a wariness of derivatives, amid continued concerns over the impact on underlying commodity prices. Inflation too is a lingering concern, with the average level of price increases expected to top 5% during 2011, a pattern Beijing is especially worried about.

Clamp down
So it is perhaps no surprise that against this backdrop, a clamp-down by regulators ensued. In October 2010, the three commodity exchanges – led by the direction of the China Securities and Regulatory Commission, enacted a raft of new rules. Chief amongst these was the introduction of position limits.

The cancellation of more than 500 trades a day is also prohibited, a rule which severely restricts exchange activity, as Chinese traders are not permitted to amend orders once entered. If a trader wishes to amend an order, the firm must cancel the trade and re-enter the deal as a new order.

The imposition of this rule is particularly difficult for the small but growing band of high frequency traders in China, which has been previously responsible for thousands of cancellations every day under the previous rules.

Exchange fees also rose significantly, including charging for both buy and sell orders. Previously only one side was charged if the contract was bought and sold on the same day. Margin requirements have also risen.

There is little doubt that the exchange-level rules have impacted the market but against that are financial measures to curb inflation, amid worries about the continued strength of China’s economic growth and concerns that a bubble is inflating. A wave of new rules was introduced by the Chinese Government, including the raising of bank reserve requirements, designed to curb the growth of credit.

So is it regulation or a wavering economy leading the decline? According to Dean Owen, China chief representative, Newedge, where he oversees the Chinese brokerage joint venture, Citic Newedge, it is difficult to say. The lower volumes are, he says, “in part due to the abnormal trading rules and increasing transaction costs, in part due to the lack of easy money nowadays with the clamp down on bank lending etc, and in part due to uncertainty over the markets”.

However, while the new wave of rules has tied the hands of Chinese traders in domestic markets, many are looking overseas for opportunities, via permitted means such as through registered Hong Kong brokers; or via the backdoor, with traders pushing the envelope, and trading outside China’s borders – something prohibited under Chinese law.

Such a trend is said by some market participants to be behind the success of some China-linked contracts, most obviously Xhinhua A50 contracts listed at the Singapore Exchange, which while the exchange has yet to publish details on where trading originates, many in the market believe Chinese-based demand is a factor in the increased volumes.

Challengers?

While Asia’s powerhouses China and India are home to Asia’s dominant commodity exchanges, new players are seeking to challenge the hierarchy. A number of new commodity exchanges have gone live in the last year, including the Singapore Mercantile Exchange and the Hong Kong Mercantile Exchange.

The SMX and the HKMEx have been designed to cater for Asia’s anticipated growth in demand for commodities, and to provide a local alternative for the funds that have traditionally flowed from Asia to the more established US and European exchanges.

The SMX has sough a balancing act, listing what could be considered global products, like WTI and Brent oil futures as well as a roster of Asian-focused contracts.

While volumes may not yet compare with the incumbent global commodity giants such as the CME Group, Intercontinental Exchange, and NYSE Liffe, V Hariharan, interim chief executive officer of the SMX says the bourse is continuing to post record-after-record volume trading days.

“What we have seen for the last month since I came here is that almost every other day there has been higher volumes,”Hariharan says.

He says that trading in SMX’s products is predominately executed within the region and demonstrates the local demand for Asian commodity trading venues; international trading firms would begin to look at the SMX with added vigour once it reaches a critical liquidity level, he adds.

The SMX chief cites several strong performing contracts listed at the new Asian exchange, including its suite of FX derivatives, which have prospered amid the continued financial crisis, but also its copper futures.

Hariharan says that copper is a key commodity in the regional futures market and the fact that SGX recently rolled out its own mini copper contract, in collaboration with the London Metal Exchange is testament to that.

“Copper also attracts volume in this part of the world because of the Chinese interest, and Indians are also attracted,” Hariharan concludes.

Hariharan admits that its global products have been less well traded than its other contracts but the exchange’s strategy was also to initially launch global products to capture the attention of trading firms but in the long-run its plan, which the interim SMX CEO says is supported by market participants, is for Asian-based contracts.

Colin Macfarlan, head of listed derivatives at Credit Suisse adds: “We see a lot of clients coming in to trade the traditional markets, like the LME, the CME Group and Nymex, but there is interest in some Asian-focused products too.”

The move to list more Asian-orientated products has been welcomed by one Singapore-based Futures Commission Merchant executive who concludes: “If the exchanges are going to be here, they should focus on here.”

The exchange is innovating and launching new products to boost its market share. Last month it announced the long awaited launch of on-exchange iron ore metal futures contracts linked to Metal Bulletin’s index bringing contracts on the index out of the OTC world for the first time.

Seeking former glory

While China may be the powerhouse of Asian commodity trading, it wasn’t always that way. Japan and Singapore dominated but for a variety of reasons, trading dwindled. However, over the last two years, Singapore and Japan’s historic commodity bourses have made a push to establish strongholds in commodity trading.

Japan’s premier commodity bourse, the Tokyo Commodity Exchange, once dominated not just Asian commodity trading but global markets. From such highs, Tocom slipped to relative lows, hampered by out-dated infrastructure and perhaps even more importantly tight regulation.

While volumes in 2010 of 27.6m contract was lower than the 28.8m contracts traded in 2009, Tocom remains confident that hard work in previous years will bear fruit.

Mitsuhiro Onosato, executive officer, at Tocom outlines the developments in recent years, “Starting with demutualisation at the end of 2008, Tocom achieved a number of reforms for market upgrades, including the adoption of the new trading system and trading rules that are in-line with global standards as well as trading hours extension.

“As a result, overseas proprietary trading houses and other new market participants have entered the market.”

Onosato says that it remains committed to implementing new initiatives to boost trading. “The exchange is implementing its midterm management plan for 2011-2013 and aims to enhance the trading environment by introducing Trade at Settlement or a similar function, revising the give-up system, among others, and strengthening clearing functions.”

All that glitters?

Onosato says upgrades to the exchange are the not the only new initiative and the exchange continues to work on developing new products. “We are working to develop new investment products based on gold futures, the exchange’s main contract, tailored to the needs of retail investors.” Onosato says.

“Also, we plan to redesign contracts to suit the needs of market participants. As for the mid-term objectives, we continue to research possibilities of establishing an emissions trading market with the Tokyo Stock Exchange Group, and of listing new contracts linked to OTC and commodity contracts-for-difference markets.”

While gold futures may be top of Tocom’s list, some have highlighted rare earth metals as a potential new product, especially in the wake of Japan’s discovery of up to 100bn tonnes of rare earths on the Pacific seabed in July.

However, Onosato says the exchange has no plans to list rare earth futures, concluding: “We don't think rare earth products are appropriate to be listed as futures contracts because of its very nature of being unstable in production, which could involve the risk of squeeze, cornering or manipulation of market.”

Enter SGX

The Singapore Exchange too has made a renewed drive in commodities since Magnus Bocker was installed as chief executive in 2009. Julie Heng, head of commodities, says the exchange has recorded an uptake in commodity trading this year.

“Commodity derivatives trading volumes have been trending upwards. Comparing the first half of this year to 2010, the rate of increase on an annualised basis is about 4%.”

SGX recently took the decision to transition its suite of commodity rubber products from its commodity subsidiary Singapore Commodity Exchange to its own trading platform. Heng says the move was to “enable more international traders to participate in the contracts, thereby enhancing liquidity and market access”.

SGX plans to migrate the remaining Sicom products in due course.

The future’s still East Asia

For the region to realise its true potential China must liberalise its financial laws, and allow, amongst other things, international access.

How important would such a move be? Well according to the legendary commodities trader Jim Rogers, who is a long-time advocate of Asian trading, China will “take over commodities world once it opens its markets and currency”.

It is a case of when not if, China opens its doors to foreigners, but it may not be anytime soon. However, Macfarlan says once they do, expect China to prosper. He says: “There are several contracts in China, like the steel rebar which is more actively traded in China than anywhere else in the world. Providing access to the market could potentially be the catalyst to push new benchmarks.”

While commodity trading in East Asia may be down, few expect the trend to continue and activity is still extremely strong. The first year on year decline in volumes in 2011 does not herald a reversal of fortunes, merely a blip on the upward trajectory of growth in the region.

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